Workshop on Transfer Pricing 7 8Aug09

Background Material

Two Day Workshop

On

TRANSFER PRICING

August 7, 2009 Hotel the Park, Parliament Street, New Delhi.

& August 8, 2009

Hotel Le Meridien, Windsor Place, Janpath, New Delhi.

Organised by

Northern India Regional Council of The Institute of Chartered Accountants of India

7th August, 2009 Dear Professional Brothers and Sisters, Namaskaram!! It gives me immense satisfaction while writing this message. The reason is that possibly, it is the first time that NIRC of the ICAI is holding a Two-day Workshop on the subject of Transfer Pricing alone. This on the one hand emphasizes the importance of the subject itself and at the same time expresses the resolve of the Regional Council to update and adequately equip its members with all types of professional work. A lot of thought and effort has gone into organizing this workshop. The theme has all along been that the subject of Transfer Pricing should no longer remain as something which is handled by a small set of firms. More and more members should be confidently able to take up various types of Transfer Pricing assignments and share their knowledge and experience with others. This workshop is going to be unique in more than one way. The distinctive feature is that the complete process of preparing a Transfer Pricing Study will be demonstrated to give a real life experience to the participants. Also, a live demonstration of the process of search for comparables by using one of the widely used databases, viz., PROWESS, is planned. Participants will also experience a practical approach in conducting a section 92E Report assignment. A separate session is dedicated to the case laws decided so far to enable all understand the key learnings from the judicial interpretations. Special care is taken to help members understand various methods of computation of Arm’s Length Price with the help of illustrations. Speakers are out of the most experienced and renowned lot and would have the best answers for any issues. This will all be done when the technical sessions are going to be chaired by the honorable high officials from the tax office who have been dealing with Transfer Pricing for years. Further, the members who are either not able to raise any queries or due to some time constraints their queries remain unanswered during the Workshop, will have a platform to take up such queries till about a fortnight after the conference and the members of the International Taxation Study Group will interact there to help members have the answers. For this, members can write to: [email protected]. I would also like to apprise members that most of the efforts in organizing this Workshop have been done by a small group of members who have come together as International Taxation Study Group of NIRC of ICAI. They are holding weekly meetings and are updating themselves on this subject which is otherwise considered to be a complex subject. I appeal to more and more members to come forward in the similar manner and take initiative to organize such programmes on matters of professional interest. I place on record the guidance and support of all the office bearers and other members of NIRC in organizing this Mega Event. With all good wishes for a pleasant and memorable “Transfer Pricing Workshop” and the Learning Experience. Warm regards,

(CA. Bhagwan Das Gupta) Chairman, NIRC of ICAI

Forthcoming Programmes of NIRC of ICAI August 2009

Date Timings Topic Organised by Venue FeesCPE Hours

7/8/2009 Hotel Park, Parliament Street, New Delhi8/8/2009 Hotel Le Meridien, Janpath, New Delhi

9/8/2009 10.00AM - 02.00 PMSeminar on Auditors's Reporting Requirements u/s 227 including CARO & Qualifications in Auditors' Report

Jointly with Dwarka CPE Study Circle

Centre for Cultural Resource & Training ( CCRT), 15A, Opp City Mall, Sec 7, Dwarka, Delhi-75 Delegate Fees. Rs.300 4

10/8/2009 05.30 PM 08.30 PMSeminar on Auditors's Reporting Requirements u/s 227 including CARO & Qualifications in Auditors' Report

Jointly with Central Delhi CPE Study Circle

Hotel Swati Delux, Gurudwara Road, Opp Jassa Ram Hospital, Karol Bagh, ND -5 Delegate Fees. Rs.350 3

12/8/2009 05.30 PM 08.30 PM *Seminar on Capacity Building of CA FirmsBY CCBCAF,ICAI & Hosted by NIRC

Hindi Bhawan, Vishnu Digamber Marg, Rouz Avenue, Delhi-02 Delegate Fees. Rs.100 3

15-8-2009 04.00 PM 07.30 PM*Diamond Jubilee Programme for Young Qualified Chartered Accountants in Industry

BY CMI, ICAI Hosted by NIRC Hotel Oasis, HD -8, Pitam Pura, Delhi-34

Less Than 5 yrs. : Regn before Aug 11 Rs. 400 and after Aug.11 Rs. 550, More than 5 Yrs. : 600 & 700 respectively 3

16-8-2009 04.00 PM 07.30 PM*Diamond Jubilee Programme for Young Qualified Chartered Accountants in Industry

BY CMI, ICAI Hosted by NIRC PSK, District Centre Laxmi nagar, Delhi

Less Than 5 yrs. : Regn before Aug 12 Rs. 400 and after Aug.12 Rs. 550, More than 5 Yrs. : 600 & 700 respectively 3

15-08-2009 16-08-2009

10.00AM - 05.00 PM followed by Cultural Evening on 15 Aug.

*National Conference on Emerging Paradigm for Accounting Professionals

BY CTLWTO,ICAI Hosted by NIRC of ICAI

Country Inn & Suits, Sahibabad, Near Dabur, Ghaziabad, Delhi NCR Delegate Fees. Rs.1250 12

16-8-2009 10.00 AM - 01.00 PM Seminar on Auditors' Reporting Requirements u/s 227 including CARO & Qualifications in Auditors' Report

Jointly with Mayur Vihar CPE Study Circle

River Side Sports Club, Mayur Vihar Phase I, Delhi -91 Delegate Fees. Rs.200 3

18-8-2009 05.30 PM - 09.30 PMSeminar on Auditors' Reporting Requirements u/s 227 including CARO & Qualifications in Auditors' Report

Jointly with North Campus CPE Study Circle

Oberoi Restaurent,A-7, Ashok Vihar Phase 3, Near Laxmi bai College,Delhi -52 Delegate Fees. Rs.250 4


Jointly with South Delhi & Safderjung Enclave CPE Study Circles

Hill Grow Public School, A-1, Safderjung Enclave, New Delhi -29 Delegate Fees. Rs.250 4

09.30 AM -06.00 PM 12Members: Rs.3000, Non

Members :Rs.5000BY NIRC of ICAITwo Day Workshop on Transfer Pricing

1


Jointly with North Ex.CPE Study Circles Hotel Oasis, HD -8, Pitam Pura, Delhi-34 Delegate Fees. Rs.350 4

21-8-2009 22-8-2009 09.30 AM -05.30 PM

*Diamond Jubilee Programme for Young Qualified Chartered Accountants in Industry

BY CMI, ICAI Hosted by NIRC

21/08/09 Hotel Crowne plaza, New Friends Colony, New Delhi 22/08/09 India Habitat Centre, Lodi road, New Delhi Plz Visit ICAI Website 12

22-8-2009 09.30 AM -05.30 AM *Regional Conference at LudhianaJointly with Ludhiana Branch

ICAI Bhawan, Near Silver Oak Palace Garden, Pakhorwal Road, Ludhiana Delegate Fees. Rs.600 6

25-8-2009 05.30 PM - 09.30 PMSeries of Seminars on Service Tax : Registration, Payment, Return, Penalty Assessment Classification, Exemption , SSI NIRC of ICAI

ICAI Bhawan, Vishwas Nagar, Shahdara, Delhi Delegate Fees. Rs.150 4

26-8-2009 05.30 PM - 09.30 PMSeries of Seminars on Service Tax : Valuation, Import & Export of Services , Audit under Service tax NIRC of ICAI


27-8-2009 05.30 PM - 09.30 PMSeries of Seminars on Service Tax : CENVAT Credit rules 2004, Refund of Service tax NIRC of ICAI


28-8-2009 05.30 PM - 09.30 PMSeminar on LLP and Auditors' Reporting Requirements u/s 227 including CARO & Qualifications in Auditors Report

Jointly with Rohini CPE Study Circles Hotel Oasis, HD -8, Pitam Pura, Delhi-34 Delegate Fees. Rs.350 4

29-8-2009 10.00 AM - 05.30 PM Full day Conference on Direct Tax : Survey Search & Seizure NIRC of ICAIHotel Intercontinental EROS, Nehru Place, New Delhi Delegate Fees. Rs.1500 6

30-8-2009 10.00 AM - 05.30 PM National Seminar on Information Technology Submit 2009Jointly with CMI & IT Committee of ICAI

Hotel Intercontinental EROS, Nehru Place, New Delhi Delegate Fees. Rs.1500 6

Seats are Limited. Enrollment for various Programmes is accepted on first come first serve basis. Memberas of All Study Group of NIRC for the year 2009-2010 are welcome to join without payment of Seminar Fees except * Marked Programmes.

2

Two Day

Workshop

On

TRANSFER PRICING

3

Transfer Pricing in IndiaTransfer Pricing in IndiaAn Overview

T A X

An Overview

T A X

G L O B A L T R A N S F E R P R I C I N G S E R V I C E S

ICAI – NIRC, New DelhiAugust 2009

Transfer Pricing – An Introduction

Indian Transfer Pricing Legislation

Budget 09 – Proposed Changes

Transfer Pricing Documentation Process

AgendaAgenda

Prescribed Methods

Transfer pricing (‘TP’) Pricing of goods,

services and intangibles within a multi-divisional

organization

Interplay of TP, division of MNCs profits among

various countries and governments efforts to

reduce tax base erosion ~ has led to the rise of

TP regulations

The arm's length principle (‘ALP’) is the condition

or the fact that the parties to a transaction are

independent and on an equal footing

IntroductionIntroduction Transfer PricingGlobal FootprintTransfer PricingGlobal Footprint

4

Comprehensive Legislation introduced with effect from April 1, 2001

Generally in line with the OECD guidelines

Compliance Requirements

Steep Penalties

Downward adjustment prohibited

Arithmetic mean concept (+/- 5percent range)

New Proposals ~ Safe harbor provisions and Dispute Resolution Panel

Maintenance of contemporaneous documentation

Annual filing of Accountant’s Report

Indian TP CodeSynopsisIndian TP CodeSynopsis

AgendaAgenda



TP LegislationTP Legislation

Sec 92C and Section 92CAAdministrative

Sec 92C, Rule 10B and 10CMethods

Sec 271(1)(c) Expln. 7, Sec 271AA, Sec 271 BA and Sec 271G

Penalties

Relevant part of the RegulationPrinciple

Sec 92D and Rule 10DDocumentation

Auditor’s Report

Definitions

Principle of Taxation

Sec 92A, 92B, 92F and Rule 10A

Sec 92E and Rule 10E

Sec 92

7B S R & Co. © 2009 B S R & Co., a firm of Chartered Accountants, duly registered under the Indian Partnership Act, 1932. All rights reserved.

ApplicabilityApplicability

Any income arising from an international

transaction shall be computed having

regard to the ALP (Sec 92)

Principle also applicable to any expense or

interest

Not applicable ~ if computation of income

or allowance for any expense has the

effect of reducing the income chargeable to

tax or increasing the loss

5


A

B

C

Both A & B are AEs of C

Outside India

India

A

B

C

D

E

D & E are also AEs of C since they have a common ultimate parent (A)

Outside India

India

Associated Enterprises (AEs)Associated Enterprises (AEs)

The above section is further supplemented by 13 clauses which enlist various conditions under which two enterprises shall be deemed to be AE’s under Sec 92A(2)

Direct or indirect participation (through one or more intermediaries) in management control orcapital – Sec 92A(1)


Associated Enterprises (AEs)DeemedAssociated Enterprises (AEs)Deemed

Common executive director(s)

Loans in excess of 51% of total assets

Guarantees in excess of 10% of total borrowings

Relationships of mutual interest

Complete dependence

on IPRs

Existence of common

control

Supply of raw materials

(90% or more)

Power to appoint more than half of

directors

Deemed AEs

Deemed AEs


International TransactionsInternational Transactions

Transactions between two or more AEs

Either or both of whom are non-residents

Transaction relates to:

− purchase, sale or lease of tangible or intangible property; or

− provision of services; or− lending or borrowing money; or− any other transaction having a bearing on the

profits, income, losses or assets of the enterprises; or

− mutual agreements or arrangements for allocation or apportionment of, or any contribution to, any cost or expense incurred

Sec 92B (1)


International TransactionsDeemedInternational TransactionsDeemed

Third parties transactions deemed to be international transaction - Sec 92B(2)

Transaction between A and 3rd party also

subject to TP norms, if:

a prior agreement exists between A’s

AEs and 3rd party; or

terms of transaction are determined

in substance by A’s AEs and 3rd

party

A’s AEsA’s AEs 3rd Party3rd Party

AA

Prior agreement/ Determination of terms

Services

Outside India

India

A’s AEsA’s AEs

3rd Party3rd PartyAA

Prior agreement/ Determination of

terms

Services

Outside India

India

6


Arm’s Length PriceArm’s Length Price

Price applied or proposed to be applied in a

transaction between persons other than associated

enterprises, in uncontrolled conditions Sec 92F(ii)

Computation of Arm’s Length Price (“ALP”)

Determination using one of the prescribed methods

Section 92C r/w Rule 10B & 10C

In case more than one price:

ALP = Arithmetic Mean of such prices (or) +/- 5

percent variance from the arithmetical mean

Proviso to Sec 92C(2)


TP DocumentationTP Documentation

Under Section 92D of the Act every person

entering into an international transaction is

required to maintain information and

documentation in support of their

international transactions

The information / documentation to be

maintained is prescribed in Rule 10D of

the Rules ~ for nine years from the

relevant financial year


TP DocumentationRequirementsTP DocumentationRequirements

Entity relatedEntity related Price relatedPrice related Transaction relatedTransaction related

– Profile of group– Profile of Indian entity– Profile of AEs

– Transaction terms– Market Intelligence– Functional analysis

(functions, assets and risk)– Economic analysis (method

selection, comparablebenchmarking)

– Forecasts, budgets

– Agreements– Invoices– Pricing related

correspondence (letters, emails etc.)

Contemporaneous documentation – Applicable onlyif the value of the international transactions exceeds INR 1 crore

Contemporaneous documentation – Applicable onlyif the value of the international transactions exceeds INR 1 crore

Law requires extensive contemporaneous documentation to be maintained


Prescribed MethodsPrescribed Methods

Prescribed Methods

Traditional Transaction Method Transactional Profit Method

ComparableUncontrolled Price

Method

ResalePrice Method

Cost Plus Method

Profit SplitMethod

TransactionalNet Margin

Method

Section 92C prescribes five methodologies to compute ALPIndian legislation provides an option to select the most appropriate method ‘MAM’

7


Accountant’s Report(Form No. 3CEB)Accountant’s Report(Form No. 3CEB)

Under Section 92E of the Act every person entering into an international transaction during a previous year shall obtain a report from an accountant and furnish such report on or before the specified date in the prescribed form duly signed and verified in the prescribed manner by such an accountant and setting forth such particulars as may be prescribed

Opinion whether– Prescribed documents have been

maintained

– The particulars in the report are true and correct

Form No. 3CEB [See rule 10E]

Report from an accountant to be furnished undersection 92E relating to international transaction(s)

1. We have examined the accounts and records ofENTITY NAME AND POSTAL ADDRESS - PAN No. relating to the international transactions entered into by the assessee during the previous year ending on 31st March 2009.

2. In our opinion proper information and documents as are prescribed have been kept by the assessee in respect of the international transaction(s) entered into so far as appears from our examination of the records of the assessee.

3. 3. The particulars required to be furnished under section 92E are given in the Annexure to this Form. In our opinion and to the best of our information and according to the explanations given to us, the particulars given in the Annexure are true and correct.

Place :Date :ForChartered Accountants


PenaltiesPenalties

2% of the value of the international transaction

Failure to furnish documents –[Sec 271G]

100% – 300% of tax on the adjustment of amount

In case of a post-inquiry adjustment, there is deemed to a concealment of income - [Sec 271(1)(c)]*

2% of the value of each international transaction

Failure to maintain documents –[Sec 271AA]

INR 100,000Failure to furnish accountant’s report -[Sec 271BA]

PenaltyDefault

*However, penalty for concealment of income shall not be levied if the taxpayer demonstrates that price charged or paid has been determined in ‘good

faith’ and with ‘due diligence’

AgendaAgenda





ALP & +/- 5%Affect of the Proposed ChangesALP & +/- 5%Affect of the Proposed Changes

When more than one price isdetermined as Arm’s Length Price (‘ALP’), the Arithmetical mean (‘AM’) of such prices is taken as the ALP

Proviso to Sec 92C(1)However, the assessee has the option of adopting an ALP which may vary from the AM by an amount not exceeding 5% of such AM

Various tribunal rulings had confirmed the availability of a 5% variance as a ‘standard deduction’

Revised Proviso

If the AM, so determined, is within 5% of the TP, then the TP shall be treated as the ALP and no adjustment is required to be made.

If not, adjustment to be computed with reference to AM.

To apply in relation to all cases in which proceedings are pending before the Transfer Pricing Officer (‘TPO’) on or after 1st October 2009.

Seeks to restrict conflicting Interpretation

• Conflict - Authorities did not give a 5% benefit where the difference between TP and ALP was > 5% of the ALP.

• Taxpayers claimed 5% as astandard deduction even in cases where the TP fell outside the range.(Development Consultants; Philips Software)

More favourable to revenueauthorities vis-à-vis taxpayers.

Existing Provisions Proposed Changes Impact

8


Application of +/- 5%An IllustrationApplication of +/- 5%An Illustration

50104B-CAs per the Taxpayer

551010A-BAs per Revenue Authorities

Adjustment

9595110110CInternational Transaction Value

99.7595115.5114BAdjusted ALP

56Less Mark-up (5%)

100100120120AArm’s Length Price (given)

ProposedPresentProposedPresent

Scenario 2Scenario 1Particulars

Overrides important Tribunal decisions that provide a liberal interpretation on the usage of +/- 5 % range


Dispute Resolution Panel (DRP)Dispute Resolution Panel (DRP)

Time-bound and fast track dispute resolution -

Applicable w.e.f. 1 October 2009

Collegium of 3 CITs appointed by CBDT

Applicability: TP adjustments by TPO and all matters

relating to foreign companies

In case of difference of opinion, decision will be taken

based on majority

Directions by DRP to be issued after giving opportunity

of being heard to taxpayer and AO

CBDT: Central Board of Direct Taxes TPO: Transfer Pricing Officer AO: Assessing Officer CIT: Commissioner of Income-tax


DRP Procedure*DRP Procedure*

TPO proposes a

TP Adjustment

AO forwards

assessment order “draft”

TPO AO

Pre Oct ‘09 Oct ‘09 Nov ‘10

Assessee

Dec ‘10

Files an objection

AO passes

the final

Order**

No

Jan ‘10

DRP issues

direction***

Yes

Jun ‘10 Jul ‘10

AO passes

the final

Order

Feb ‘10

* Applicable for all Audits concluded by AO post 1 October 2009 ** One month from the end of the month in which acceptance is received or objection period expires*** Time limit of 9 months from the end of the month in which the draft order is made available to the assessee# Additional time after which demand notice will be issued incase AO passes an order under DRP’s directionITAT: Income-tax Appellate Tribunal CIT(A): Commissioner of Income-tax (Appeals)

Issue of demand notice

9 Months (approx.)#

CIT(A)

ITAT

Right to M

utual Agreem

ent Procedure (M

AP) not forfeited


DRP & MAPDRP & MAP

Matter adjudicated favourably by DRP ~ impact on similar matter pending for prior years

Order should be binding

Department should

concede

Should have persuasive

value for CA

CIT(A) ITAT MAP

Need for consequential legislative amendment for similar prior year matters pending in appeal before CIT(A) and ITAT

9


DRPPros and ConsDRPPros and Cons

ProsSpecialist three member panel

Direct appeal to ITAT possible

Definite time limit

Provides certainty to MNEs operating in India

Cons & Technical ConflictsIf the taxpayer does not respond to the draft order will it be akin to conceding?

Will the DRP be available in each location?

No revision possible

In situations where case is not referred to the TPO and the order is passed by the AO himself, will the DRP process be available?

Will the DRP issue directions on other matters also?


Safe Harbour ProvisionsSafe Harbour Provisions

CBDT to formulate safe harbour provisions

Applicable w.e.f. 1 April 2009

‘Circumstances’ in which the revenue

authorities shall accept the TP declared by the

taxpayer

Conservative definition of provisions would

nullify the potential benefit

To reduce the impact of judgemental errors in

TP

Significant attempt to reduce litigation and provide certainty in specific circumstances


Internationally used safe harbours take two forms –

1. Exclusion of certain classes of transactions (based on quantitative limits) from TP regs; and

2. Stipulation of margins / thresholds for prescribed classes of transactions/ specified industries

Safe Harbour International ExperienceSafe Harbour International Experience

FEW EXAMPLES:

Mexico has established the following safe harbours for the activity of Maquiladoras, viz. (i) 6.5% return on total costs; (ii) 6.9% return on value of assets employed.

For intra group services (5% mark up) & intercompany loansSwitzerland

Safe Harbour RuleCountry

In respect of preparation of contemporaneous documentationTaiwan

USA

Brazil

Australia/ New Zealand

Royalty/ technical know-how/ interest payment

For intra group services – Service Cost Method & low end services

For certain category of non-core intra group services


Safe HarbourArea of ConcernSafe HarbourArea of Concern

Difficulty in defining ‘qualitative’ thresholds

Inconsistency in field application due to lack of suitable guidance

Non-acceptance by overseas tax jurisdiction may result in double taxation - Harmonisation of ‘safe harbour’ with international standards

Anticipate a ‘two-step’ process

1 Rules for rudimentary transactions (cross-charges, management fees, royalty, etc.)

2 Rules for complex transactions (industry-specific)

MAP resolution to consider Safe Harbour rules

10


uestions??29B S R & Co. © 2009 B S R & Co., a firm of Chartered Accountants, duly registered under the Indian Partnership Act, 1932. All rights reserved.





AgendaAgenda

GatheringBackgroundInformation

FunctionalAnalysis

TP Documentation

EconomicAnalysis

IndustryAnalysis

TPProcess

TPProcess

1

2

3

4

5

TP ProcessTP Process

Group Overview

Group’s business activities/ operations/ divisions

Products and services

Geographical presence

Any significant developments during the year

Company Overview

Evolution

Shareholding Structure

Overview of operations

Key business areas, customers, products/services etc.

Any significant events during the year

STEP 1


FunctionalAnalysis

TP Documentation

EconomicAnalysis

IndustryAnalysis

TPProcess

TPProcess

1

2

3

4

5


Group Overview





Company Overview

Evolution





STEP 1FAR Analysis

Assists in mapping of economically relevant facts and characteristics of inter-company transactions with regard to their Functions Performed, Assets Utilised and Risks Assumed

Identify the location of KERT/ SPF

Analyze the schedule of ‘Executive Authority’

Analysis of KPI’s of the key management personnels

Study MIS to ascertain the factual matrix

STEP 2

11


FunctionalAnalysis

TP Documentation

EconomicAnalysis

IndustryAnalysis

TPProcess

TPProcess

1

2

3

4

5


Group Overview





Company Overview

Evolution





STEP 1FAR Analysis






STEP 2

Industry Overview - “An analysis of the conditions affecting the industry, the nature of competition experienced, economic and regulatory factors”

Assists in understanding the client’s relative positioning in the industry vis-à-vis other players

Helps in screening factors when undertaking a comparables search – Qualitative analysis

Provides overall justification of client’s financial results

STEP 3


FunctionalAnalysis

TP Documentation

EconomicAnalysis

IndustryAnalysis

TPProcess

TPProcess

1

2

3

4

5


Group Overview





Company Overview

Evolution





STEP 1FAR Analysis






STEP 2





STEP 3

Economic Analysis - The objective is to identify comparable transactions that allow the assessment of the ALP of the relevant transaction. Includes the following steps:

Selection of tested party

Selection of Most Appropriate Method

Benchmarking Analysis

Choice of relevant Profit Level Indicator (PLI)

Working Capital /Other relevant Adjustment

Determination of arm’s length results

STEP 4


FunctionalAnalysis

TP Documentation

EconomicAnalysis

IndustryAnalysis

TPProcess

TPProcess

1

2

3

4

5


Group Overview





Company Overview

Evolution





STEP 1FAR Analysis






STEP 2





STEP 3

Economic Analysis - The objective is to identify comparable transactions that allow the assessment of the ALP of the relevant transaction. Includes the following steps:



Benchmarking Analysis

Choice of relevant Profit Level Indicator (PLI)

Working Capital /Other relevant Adjustment

Determination of arm’s length results

STEP 4






AgendaAgenda

Prescribed Methods

12


Prescribed MethodsPrescribed Methods

Prescribed Methods

Traditional Transaction Method Transactional Profit Method

ComparableUncontrolled Price

Method

ResalePrice Method

Cost Plus Method

Profit SplitMethod


Method

Section 92C prescribes five methodologies to compute ALPIndian legislation provides an option to select the most appropriate method ‘MAM’


TP methodsSelection of the MAMTP methodsSelection of the MAM

MAM shall be the method best suited to the facts and circumstances of

each particular international transaction and which provides the most

reliable measure of an ALP in relation to the international transaction

Factors considered for selection of the MAM:

− Nature and class of international transaction

− Class of associated enterprise and functions performed

− Availability, coverage and reliability of data

− Degree of comparability between the International transaction

− Extent to which reliable and accurate adjustments can be made

− The nature, extent and reliability of assumptions for application of

the method

Rule 10C


Selection of the Tested PartySelection of the Tested Party

Tested party is generally the participant in the international transaction

whose transfer price / profitability attributable to the controlled transactions can be verified using the most reliable data and

requiring the fewest and most reliable adjustments and

for which reliable data regarding uncontrolled comparable companies can be located

In most cases, the tested party will be the least complex of the transacting AEs and does not own valuable intangible property or unique assets that starkly distinguish it from potential uncontrolled comparable companies.

Case: Special Bench decision in case of Ranbaxy Laboratories Limited

The Tribunal has held that even though the least of the complex parties should be selected as the tested party;

if information is available for comparable transactions / parties as regards the complex entity, the same should be selected for the analysis

CUPMeaningCUPMeaning

A TP method that compares the price for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.

Controlled Transaction

Comparable Uncontrolled Transaction

Comparability

– Functions

– Contractual terms

– Risks

– Economic conditions

– Strong similarity of

products and services

Other Key Attributes

– Direct and Reliable

Method

– Generally produces the

most reliable results

– Depends on availability

of comparable data

13

CUP follows strict

comparability

As very high degree of

comparability required

Neither Gross Profit

nor Net Operating

Profit is used

HighComparability Requirements Approach Prices are

benchmarked

Very Difficult but most preferred method

Application

Profit Level Indicator is not examined

CUPMeaning…contd.CUPMeaning…contd.

CUPMethodsCUPMethods

External CUPMethodsInternal CUP

Parent Co.

Sub Co. Unrelated Co. X

Internal CUPTransfer P

rice Outside India

India

Unrelated Co. Y

Unrelated Co. Z

External C

UP

Rule 10B stipulates the methods of determination of ALP. The Rule has prescribed certain steps for arriving at arm’s length price under different methods.Following table depicts the steps followed under CUP method for determination of ALP

xxxxAdjusted Price = Arm’s Length Price

xxxxAdjustments for material differences

xxxxPrice charged/ paid in comparable uncontrolled transaction

AmountParticulars

Step 2

Step 3

Step 1

All adjustments in the course of applying the method are to be made to the price charged in the uncontrolled transaction

Only differences that would materially affect the price in the open market are required to be adjusted

Averaging is permissible only if a range of arm’s length prices have been arrived at

CUPApplicationCUPApplication

Geographical conditions should be checked as to whether there is any price variance due to regulations prevalent in different territory or are there any other factor affecting the pricesShould check whether the same could

be adjusted in the comparable price

Market conditions should be checked as to whether there is any price variance between Red and Green Apple due to difference in taste or other attributesShould check whether the same could

be adjusted in the comparable price

A client is a distributor of Red Apples, importing the same from its AEs in Australia

Available Information: Import Price for Red Apple charged by an independent party in US

Query: Whether the price of Red Apple (US) can be used as CUP for benchmarking the import transaction of Red Apples (Australia) ????

A client is a distributor of Red Apples, importing the same from its AEs

Available Information: Import Price for Green Apple charged by an independent party

Query: Whether the price of Green Apple can be used as CUP for benchmarking the import transaction of Red Apples ????

Case 2Case 1

CUPIllustrationCUPIllustration

14

CUPIssues in ApplicationCUPIssues in Application

Can localised product be used as CUP for Imports ????

Availability of Data

Custom Valuation Methodology– Identical / Similar goods

Information on competitor prices can be obtained by exercising powers u/s 133(6)

Information provided to Customs authorities used for making adjustment in TP

Acceptable source of information for CUP : - Third party invoices or Price catalogue or quotations

Application of 5% range in case of single CUP

CPLMMeaningCPLMMeaning

Method: Compares the gross-profit margin on direct and indirect costs incurred with that of comparative uncontrolled transactions

Applicability: manufacture, assembly or production of tangible products or servicesthat are sold to or provided to the AEs

Gross margins are used as the PLI

Large emphasis on functional comparabilityMarkets, Strategies etc.

Tolerant to Product Differences – fewer adjustments may be necessary

Parent A

Indian Manufacturer(AE – India)

Similar Manufacturer(Third Party)

Unrelated entity

Gross Margin

CPLMIllustrationCPLMIllustration

X Ltd. – Software Development + onsite and offsite consultancy services

Y Ltd. (AE)

M Ltd. (Third Party)

100 man-hours @ INR 2,000 per man-hour

Total Costs incurred

(INR 175,000) @ INR 3,000 per man-hour

GP margin earned on costs 50 %

X Ltd. derives technology support from Y Ltd.(20 percent of normal GP)

X Ltd. offers Y ltd. a quantity discount(10 percent of normal GP)

Marketing Risks associated with services rendered to customers other than Y ltd.(10 percent of normal GP)

X Ltd. offered one month’s credit to Y Ltd.(1.5 percent GP)

DIF

FER

ENC

ES

Arm’s Length Price for transaction between X Ltd. and Y Ltd. ?

CPLMIllustration...contd.CPLMIllustration...contd.

1.5% Sub-total (C)

30,125Increased Income INR (230,125 – 200,000)

230,125Arm’s length Income (INR)

31.50%Arm’s length GP mark-up = (A) – (B) + (C)

1.5% Cost of credit to Y Ltd.

Add:

20% Sub-total (B)

(05%)Risk factor non existent with Y Ltd. (10% of 50%)

(05%)Quantity Discount to Y Ltd. not to M Ltd. (10% of 50%)

(10%)Technology Support from Y Ltd. (20% of 50%)

Less:

50 %G.P mark-up in comparable uncontrolled transaction (A)

175,000Direct and Indirect Costs (INR)

15

CPLMIssues in ApplicationCPLMIssues in Application

Identification of ‘Direct’ and ‘Indirect’ costs

Cost Determination Costs may not be determinant/ reflective of the appropriate profit in specific case for any one year

- competition to scale down prices

- no discernible link between the level of costs incurred and market price

Comparable mark-upComparable mark-up to be applied to a comparable cost base

- Leased assets v. Owned assets; Different accounting practices

Expenses reflecting functional difference (or) additional functions

Treatment of assets under the CPMFinance Cost

Whether the finance costs should be included in the cost base?

Pass/ Flow through cost for application of mark-up

RPMMeaningRPMMeaning

Compares the resale gross margin earned by associated enterprise with the resale gross margin earned by comparable independent distributors

Preferred method for a distributor buying purely finished goods from a group company (if no CUP available)

To be applied when a goods purchased or service obtained from an AE is resold to an unrelated enterprise.

Under this method comparability is less dependent on strict product comparabilityand additional emphasis is on similarity of functions performed & risks assumed

Parent Co.

Sub Co.

Transfer Price INR 75

Unrelated Co. Y

Resale Price INR 100

Outside India

India

Price paid by Sub Co. to AE is at arm’s length if the 25% resale margin earned by Sub Co. is more than margins earned by

similar Indian distributors

A Inc., is a leading manufacturer of laptops;

A Inc., sells the laptops only through its subsidiaries.

There are no direct sales by A Inc.,

A Ltd a wholly owned subsidiary of A Inc., acts as a distributor of the products in the Indian Sub-continent;

The Group operates on a business model whereby the distributor location would function as a trader in the laptops;

A Inc., would supply the warranty replacements free of costs to A Ltd.

A Ltd, also trades in Desktops manufactured by X Inc., an uncontrolled entity;

X Inc., would provide warranty replacements free of costs to A Ltd.

RPMIllustrationRPMIllustration

RPMIllustration…contd.RPMIllustration…contd.

5050Other expenses incurred by A Ltd on import9501150Sale price by A Ltd in India7501000Purchase price by A LtdX Inc in USD P.U.A Inc., in USD P.U.Particulars

16.67%Resale Margin

750Purchase Price

900Adjusted Price

50Expenses incurred by A Ltd on import

950Sale price of Desktops in India

Amount in USDParticulars

1000Purchase price from AE’s

917Resale Price

16.67%Resale Margin

1100Adjusted Price

50Expenses incurred by A Ltd on import

1150Sale price of Laptops in India

Amount in USDParticulars

Is the Transaction at Arms Length?

16

RPMIssues in ApplicationRPMIssues in Application

Losses at ‘net level’ - Roche Products Pty Ltd. and Commissioner of Taxation

Entrepreneurial distributor Vs Low Risk Distributor

Business Expenses incurred in case of Purchase

Application of +/- 5 % range

Unlike the US regulations and the OECD regulations, the Indian regulations recognise the use of RPM for benchmarking the cases involving the resale of services - Development Consultants (P) Limited Vs DCIT, Circle 2, Kolkata

Only cost of goods sold is benchmarked and not purchases made during an assessment year (as reported in the Form No. 3CEB)

Relatively difficult to apply where

• Goods are further processed before resale• Significant Value Addition and creates or maintain Marketing Intangibles/ IP• Sales to AE• Reliable adjustments cannot be made

PSMPSM

Applicability: To be applied in cases involving transfer of unique intangibles or in

multiple international transactions that cannot be evaluated separately

E.g. : Where services are interrelated, independent parties might choose to set up a partnership

or form a joint venture and allocate profits according to services performed

Calculates the combined operating profit resulting from an inter-company transaction

based on the relative value of each AEs contribution to the operating profit

Evaluates allocation of combined profit/ loss in controlled integrated transactions

The contribution made by each party is based on a functional analysis and valued, if

possible, using external comparables

PSMApplicationPSMApplication

Two approaches discussed by the OECD guidelines

Determine the combined net profit of the AEs engaged in IT

Evaluate relative contribution made by each of them with regard to FAR + external market data

Split the combined profit in proportion to relative net contribution

Profit so apportioned – taken to arrive at ALP in relation to IT

Allocate income to routine contributions

Allocate Residual Profits/ (Losses)

Total net profit – two-stage allocation –taken to arrive at the ALP in relation to IT

Contribution Analysis/ Comparable Profit Split

Residual Analysis/ Residual Profit Split

Stage - 1

Stage - 2

PSMIllustrationPSMIllustration

XYZ (U.S. Corporation)

Nulon – Chemical formula

Patent Protection

U.S. market for bulletproof material

Substantial Share

XYZ - Europe(European Subsidiary)

License to manufacture and market Nulon in Europe

Research Unit

Alters Nulon to adapt it to military

specifications

Marketing Network/ Brand Names

High intensity marketing campaign – Defense industry

XYZ – Europe manufactures and sells Nulon in Europe through its marketing network under one of its brand names

17

PSMIllustration…contd.PSMIllustration…contd.

180Residual profit

20Market return for XYZ – Europe’s Nulon business

10 percentAverage market return on XYZ - Europe’s operating assets

200Operating assets (employed in Nulon’s business)

200C = A - BNet pre-royalty profit

B

A

Ref

300Pre-Royalty Expenses

500Nulon Sales

US$ (million)XYZ - Europe

European Brand Name Nulon’s Formula (including XYZ – Europe’s modifications)

Attributable to valuable intangibles related to Nulon

PSMIllustration…contd.PSMIllustration…contd.

Relative Values of the Intangibles

Previous Year’s capitalized values of expenditures on Nulon-related research & development and marketing over last year’s sales related to such expenditure

0.60Capitalized intangible development expenses for each dollar of XYZ – Europe’s protective product sales

-

0.20

XYZ

0.40XYZ-Europe’s expenditure (R&D and Marketing) (per $ of XYZ – Europe’s Nulon Sales)

-Capitalized R&D expenditure (per $ of protective product sales)

XYZ - Europe

1/3rd of $180 million of residual Nulon profit = $60 million

Arm’s length royalty

1/3rd

Limitations/ Issues

Can be difficult to determine the relative value of contribution that each of the related participant makes

Less direct approach than CUP, RPM and CPM

May be difficult to allocate costs specifically to the property or services provided in the controlled transactions

PSMIssues in ApplicationPSMIssues in Application

TNMMMeaningTNMMMeaning

Examines net operating profit from transactions as a percentage of a certain base (can use different bases i.e. costs, turnover, etc) in respect of similar parties

Ideally, operating margin should be compared to operating margin earned by same enterprise on uncontrolled transaction – Internal TNMM

Most frequently used method in India, due to lack of availability of comparable uncontrolled prices and gross margin data required for application of the comparable uncontrolled price method / cost plus method / resale price method

Broad level of product comparability and high level of functional comparability

Applicable for any type of transaction and often used to supplement analysis under other methods

The application of the TNMM to a specific tested party breaks down when factors other than transfer prices have a material impact upon profits

Usually regarded as an indirect and one-sided method, but is most widely used

18

TNMMStep involved in its ApplicationTNMMStep involved in its Application

Grouping of transaction - Relevant controlled transactions require to be aggregated to test whether the controlled transaction earn a reasonable margin as compared to uncontrolled transaction

Selection of tested party - Least complex entity

Selection of Profit Level Indicator such as Operating Margin, Return on Value added expenses, Return on assets – Unaffected by the transfer price

Benchmarking exercise

− Entity with similar industry classification to the tested party – thru search in Prowess and Capitalineplus databases

− Screen entities by applying appropriate quantitative filters, such as mfg sales >75%, R&D exp >5%, Advertisement exp >5%.

− Review financial and textual information available in the public database of the selected entities – for qualitative filters

Computation of ALP

− Usage of single year data / multiple year data

− Computation of arithmetic mean

TNMMChoice of PLITNMMChoice of PLI

Typically Used ForFormulaePLI

Low Risk Distributor{Berry Ratio (GP/VAE)-1}OP/VAE

Manufacturer/Distributor/Service Provider

Net or Operating Profit/Total assets –Current LiabilitiesROCE

Manufacturer/Distributor/Service provider

Net or Operating Profit/Operating assetsROA

Manufacturer/Distributor/Service provider

Net or Operating Profit/Net sales or net turnoverNet or Operating margin

Manufacturer/Service provider

Net or operating profit/Total costs (Total costs = COGS + OPEX)

Net/Full cost plus (Return on total costs)

TNMMStrengthTNMMStrength

Can be applied to all types of business – manufacturing / service / trading

Less complex functional analysis is required

Net profit (“NP”) margin compared in TNMM are less affected by transactional differences e.g. price or gross profit margin

The net margin is more tolerant to some functional differences than gross profit margin

Under TNMM functions performed and responsibilities assumed by tested party and associated enterprise (“AE”) have less impact on determination of Arms Length Price (“ALP”)

It is not necessary that all AE should maintain accounts and allocate costs in identical manner

TNMMWeaknessTNMMWeakness

The net margin of a taxpayer can be influenced by some factors that either do not have an effect, or have a lesser effect, on price or gross margin e.g. higher depreciation or under absorption of cost in start up phase

Lack of information / reliable information about uncontrolled transactions at the time of entering controlled transaction

Also, may not have access to information on the profits attributable to uncontrolled transaction

There may be difficulties in determining an appropriate corresponding adjustment when applying the transactional method, particularly where it is not possible to work back to transfer price

TP MethodSnapshotTP MethodSnapshot

Comparability Requirements Approach

CUP Very High Prices benchmarkedVery difficult but most

preferred method

Application

CPLM High Gross Margin benchmarkedManufacturer/ Service

Providers

RPM High Gross Margin benchmarked Distributor/ Services Providers

PSM Medium Net Margin benchmarkedManufacturer/ Distributor/

Service Providers

Medium Net Margin benchmarkedManufacturer/ Distributor/

Service ProvidersTNMM

19

Two Day

Workshop

On

TRANSFER PRICING

20

Transfer PricingMost Appropriate Method & Search for Comparables

August 7, 2009

Agenda

Computation of Arm’s Length Price

Profit Level Indicators

Range Computation

Multiple year data

TP Assessment: Framework and Emerging Issues

Case Study

Sample search process

OECD Guidance

Questions

Transfer Pricing Legislation in India

International Transactions International Transactions

betweenbetween

Associated EnterprisesAssociated Enterprises

at at

ArmArm’’s length prices length price

supported bysupported by

Extensive contemporaneous documentationExtensive contemporaneous documentation

Effective date: Financial Year beginning April 1, 2001Effective date: Financial Year beginning April 1, 2001

Computation of Arm’s Length Price (ALP)

21

By use of any of the prescribed methods being the ‘most appropriate’ methodhaving regard to :

nature of transaction

class of transaction

class of associated persons

functions performed by such persons

Computation of ALP [Section 92C (1)] Selection of Most Appropriate Method (MAM) [Rule 10C]

Rule 10C(1) - MAM shall be the method which is:

best suited to the facts and circumstances of each particular international transaction, and

provides the most reliable measure of ALP

Rule 10C(2) -Factors determining the MAM

Nature and class of international transaction

Class of associated enterprises and functions performed

Availability and reliability of data

Degree of comparability

Extent and reliability of adjustments

Nature, extent and reliability of assumptions

Prescribed Methods for computation of ALP

Traditional Transaction

Comparable Uncontrolled

Price(“CUP”)

Resale Price

Method(“RPM”)

Cost Plus

Method(“CPM”)

Methods for computation of ALP

Transactional Profit based

ProfitSplit

Method(“PSM”)


Method (“TNMM”)

Such other method as may be prescribed by the board

Comparable Uncontrolled Price Method (CUP)

The CUP Method seeks to determine the arms’length price by comparing the controlled transaction with the uncontrolled transaction

Method used in case of strong similarity of products or servicesMost direct and reliable method – preferred by OECDGenerally produces the most reliable results Comparability based on:

FunctionsContractual termsRisks Economic conditionsStrong similarity of products and services is critical

Manufacturerin US

AE in IndiaUnrelated

Party in India

Manufacturer in US, manufactures electronic chips which are sold to both AE, a related party in India, and unrelated Indian customers

CUP

Sale price to unrelated party may be used to benchmark sale to group entity in India

22

Resale Price Method (RPM)

Method used in case of purchase of goods or services from related parties for resale to unrelated parties without substantial value addition

The price is reduced by the normal gross margins earned by unrelated party for same or similar products or services

Need for similarity of functions performed and risks undertaken

Gross margins used as the profit level indicator

Group Manufacturerin US

Distributorin India

UnrelatedWholesaler

An Indian distributor purchases watches from its US manufacturerfor resale to unrelated wholesalersin India. Indian distributor earns a gross margin of 25%

Price paid by Indian distributor to Group manufacturer in US is the arm’s length price if the 25% resale margin earned by Indian distributor lies within arm’s length range of margins earned by similar Indian distributors

$ 75

$ 100

Cost Plus Method (CPM)

Method used in cases involving manufacture, assembly or production of tangible products or services that are sold / provided to related partiesThe mark up on direct and indirect costs of production incurred to be based on unrelated comparablesNeed for high similarity in functions performed and risks borneGross margins used as the profit level indicator

External Market in US

AE in US

Indian manufacturer makes

electronic components and sells

these at fully absorbed cost plus

40% to a US manufacturer which

uses those components in

manufacture of electric power tools

ManufacturerIn India

Margin earned by Indian manufacturer on cost to Group manufacturer to be benchmarked against margin on total costs (direct and indirect production costs) earned by similar manufacturers in India

Transactional Net Margin Method (TNMM)

Examines operating profit from transactions as a percentage of appropriate base (can use different bases i.e. costs, turnover etc.) in respect of similar parties

Broad level of similarity of resources employed, functions and risks

Operating margin of Indian company to be compared with operating margin earned by similar enterprises in uncontrolled transactions

Most preferred and practical method vis-à-vis the assesses.

Subsidiaryin India

AE in USUnrelatedCompany

UnrelatedSubsidiary in

India

Profit Split Method (PSM)

Method used in cases involving transfer of unique intangibles or in multiple international transactions that cannot be evaluated separately

Evaluates allocation of combined profit/loss in controlled integrated transactions

Reference to relative value of each controlled taxpayer’s contribution (functions performed, risks assumed and resources employed)

Complex Method/ Sparingly used

23

MAM

Organization for Economic Cooperation and Development (OECD) advocates the use of Traditional transaction methods (CUP, RPM and CPM) over Transactional profit methods (PSM and TNMM) [Chapter III,3.49]

Flexibility granted to taxpayer for selection of MAM

No preference for any particular method under Indian transfer pricing law

Method Transaction Type

CUP Loans, Royalties, Service fee, transfer of tangibles, etc.

RPM Marketing operations of finished products, where distributor notperforming significant value addition to product

CPM Raw material or semi-finished goods are sold, long term buy-and-sell agreement

PSM Transactions involving provision of integrated services by more than one enterprise or involving unique intangibles

TNMM Provision of services, transfer of semi-finished goods, distribution of finished goods where applicability of RPM is inappropriate, etc.

Choice of MAM : General applicability

Profit Level Indicators

All methods, with the exception of CUP, examine a PLI relevant to the method

Specified financial ratio of the tested party is compared to the results of independent, functionally comparable companies

Choice of Profit Level Indicators (PLIs)

24

Choice of PLIs

Method PLI Formula Typically used for

RPM Gross margin Gross Profit/Sales Distributor

Cost Plus Gross cost plus margin

Gross Profit/DICOP (Direct & Indirect Cost of Production) Manufacturer

TNMM/ Full Cost Plus

Net/Full cost plus (Return on total costs)

Operating profit/Total Costs Manufacturer/

Service provider

TNMM Operating margin Operating Profit/Net sales or net turnover

Manufacturer/

Distributor

TNMM ROA Operating Profit/Operating assets Manufacturer

TNMM ROCE Operating Profit/ Capital Employed Manufacturer

The Methods

Comparable Uncontrolled PriceComparable Uncontrolled PriceTURNOVERTURNOVER

(COST OF SALES)(COST OF SALES)

GROSS PROFITGROSS PROFIT

(DISTRIBUTION AND (DISTRIBUTION AND ADMINISTRATION ADMINISTRATION

EXPENSES)EXPENSES)

OPERATING PROFITOPERATING PROFIT

Resale Price MethodResale Price Method Cost Plus MethodCost Plus Method

TNMM MethodTNMM Method Profit Split MethodProfit Split Method

Range Computation

Scenario before the amendment

Options under proviso to Section 92C (2)

where more than one price is determined by the most appropriate method

the ALP shall be taken to be the arithmetical mean of such prices

OR

a price which may vary from the arithmetical mean by an amount NOT exceeding 5% of such arithmetical mean at the option of assessee

Range computation

25

Budget 2009-10… Amendment

The Indian Union Budget 2009-10 has proposed a fundamental amendment to the current proviso to Section 92 C(2)

"Provided that where more than one price is determined by the most appropriate method, the arm's length price shall be taken to be the arithmetical mean of such prices”

“Provided further that if the variation between the ALP so determined and price at which the international transaction has actually been undertaken does not exceed five per cent of the latter, the price at which the international transaction has actually been undertaken shall be deemed to be the arm's length price."

Illustration -Range Computation

Say, Full Cost (for a captive service provider) US$ 100.00

Arm’s length mark up (Mean) 10%

Taxpayer's actual mark up :

Case "A" 5%

Case "B“ 3%

Arm’s length service fees [@ 10% mark-up] US$ 110.00

Applying (-5)% [95% of US$ 110] US$ 104.50

As per existing provisions

Case "A”Taxpayer’s fees charged to related party ==> US$ 105 [No TP adjustment , as taxpayer's transfer price is more than US$ 104.50]

Case "B"Taxpayer’s fees charged to related party ==> US$ 103 [TP adjustment to the tune of only US$ 1.50 (i.e. 104.50 – 103)

Illustration - Range Computation…Cont

Proposals in Budget [negating favorable ITAT rulings]*

Case "A"

Taxpayer's fees charged to related party ==> US$ 105

“Variation” by using 5% on US$ 105 ==> US$ 110.25

Arm's length service fee [@ 10% mark-up] ==> US$ 110

Still no TP adjustment, as US$ 110.25 > US$ 110

*ITAT Rulings - Development Consultant’s Pvt. Ltd.

- Skoda Auto India Pvt. Ltd.

- Mentor Graphics (Noida) Pvt. Ltd.

Illustration -Range Computation….Cont

Case "B"

Taxpayer's fees charged to related party ==> US$ 103

“Variation” by using 5% on US$ 103 ==> US$ 108.15

Arm's length service fee [@ 10% mark-up] ==> US$ 110

TP adjustment of US$ 7 [110 - 103], as US$ 108.15 < US$ 110 [in case of existing provisions, TP adjustment was only US$ 1.50]

26

OECD guidelines vs. Indian Regulations

Transfer Pricing not exact science a range of arm’s length price possible, particularly in TNMM [para 1.45 of OECD TP guidelines]

Extreme results indicate abnormal business conditions generally excluded from arm’s length range [Section “B” of Chapter on “Definition of arm’s length range, etc” of OECD discussion draft on comparability, 2006]

Arithmetic mean results distorted due to extreme values (outliers); (+)/(-) 5% range not sufficient remedy

Median less susceptible to distortion on account of extreme values, as outliers affect median less better measure of central tendency

Global Best Practices Use of Median & inter-quartile range to obtain a converging set of arm’s length prices

Multiple Year Data

Rule 10B(4) Comparable benchmarking based on data relating to financial year in which controlled transactions entered into by taxpayer

Also, prior-year data up to 2 years may be used if it has an influence on transfer price [proviso to rule 10B(4)]

Tribunal Rulings [Mentor Graphics (Noida) Pvt. Ltd, Aztec Software and Technologies, Skoda Auto India Pvt Ltd, Honey Well Automation India Pvt Ltd] have held that only current year data can be used for comparable benchmarking, prior-year data to be used only in exceptional circumstances covered by proviso to rule 10B(4)

Indian transfer pricing regulations provide [Section 92D(1), Rule 10D(4)] :

• Mandatory annual documentation • Need to complete documentation before due date of filing of tax return 30th September

Mandatory usage of current-year data in India for documentation & transfer pricing audit Impossibility of performance, especially in case of profit based methods using external comparables

Contemporaneous Data OECD Discussion Draft on Comparability, 2006

OECD Discussion Draft specifies 3 scenarios for determining timing/ cut-off for carrying comparable benchmarking searches [sections “B” & “C” of Chapter on “Timing Issues in comparability”] :

a) In case upfront price setting planning policy carried out benchmarking at time of planning is sufficient compliance

b) In case no upfront planning policy carried out, but relevant country provides mandatory documentation compliance within specified date (generally return filing date) cut off for benchmarking should not traverse beyond date for documentation compliance

c) In case no upfront planning policy carried out & also relevant country does not provide mandatory documentation compliance within specified date cut off for benchmarking at time of transfer pricing audit

Where taxpayer has not carried out upfront planning policy, India falls in scenario (b) Cut off should not traverse beyond return filing date

27

Databases used in India Limitation on availability of data as on return filing date

Data Availability Analysis in Prowess

74506853 7090

8280

30642413 3071 2591

31%43%35%41%

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

FY 2004-05 FY 2005-06 FY 2006-07 FY 2007-08

Universe of Companies (A)

Companies reporting data in current year (B)

Percentage of Companies for which data is available for current year (B/A)

Data Availability Analysis in Capitaline(Excluding additional companies in Prowess approximately 80%)

14611581

14261596

515616655699

44% 45% 43% 33%

0

200

400

600

800

1000

1200

1400

1600

1800

FY 2004-05 FY 2005-06 FY 2006-07 FY 2007-08

Universe of Companies (E)Companies reporting data in current year (F)Percentage of Companies for which data is available for current year (F/E)

h



Overall Data Availability Analysis (Prowess & Capitaline combined)

83149861

85169046

310636873763

3068

31%37%42% 43%

0

2000

4000

6000

8000

10000

12000

FY 2004-05 FY 2005-06 FY 2006-07 FY 2007-08

Years

No.

of C

ompa

nies

Universe of Companies(U)Total Companies reporting data in current year (V)Percentage of Companies for which data is available for current year ((V/U)

Data Availability – Need for multiple-year data

Only 30% of comparables in databases reflect current-year data as on return filing date, i.e. 30th

September [appx 40% as on 31st October (till AY 2007-08)]

No sufficient number of comparables for preparing representative sets for transfer pricing analysis

Usage of current year data available as on return filing date Impossibility of performance

Usage of current year data available at time of Revenue Audit (generally 3 years after closure of financial year) against OECD principles, as Indian transfer pricing regulations require mandatory documentation compliance within return filing date

Thus, usage & acceptance of multiple year data should be made automatic in transfer pricing regulations/ CBDT circulars, etc [clarificatory amendment]

Further, OECD also recommends usage of multiple-year data as best practice for comparability analysis

28

OECD guidelines – Need for multiple-year data

• Complete understanding of facts surrounding controlled transaction [para 1.49 of OECD TP guidelines]

• Veracity of business strategies e.g. market penetration [para 1.33 of OECD TP guidelines]

• Smoothen fluctuations caused by business & product life cycles [para 1.50 of OECD TP guidelines]

• Evaluation of loss making situations [section C-2 of Chapter on “Multiple year data” of OECD discussion draft on comparability]

• Evaluation of volatility & corresponding functional, asset & risk profile [section C-3 of Chapter on “Multiple year data” of OECD discussion draft on comparability]

Business&

Product Life Cycles

Loss Strategies

Evaluate reasonable time for an enterprise

to sustain loss

Smoothen out fluctuations caused by

different business cycles

Prevent cherry picking

Cover economic cycle

Business strategies may

affect profitability temporarily

Global Best Practices

Sl. No. Country Database Usage of Data 1 Australia BvD - OSIRIS 3 out of 5 years2 Australia BWW 3 out of 5 years3 China BvD - OSIRIS 2 out of 3 years4 Denmark BvD - AMADEUS 3 out of 5 years5 Finland BvD - AMADEUS 3 out of 5 years6 France BvD - AMADEUS 2 out of 3 years7 Germany BvD - AMADEUS 3 out of 5 years8 Italy BvD - AIDA 2 out of 3 years9 Netherlands BvD - AMADEUS 2 out of 3 years10 Russia BvD - AMADEUS 3 out of 5 years11 South Africa BvD - AMADEUS 3 out of 5 years12 Spain BvD - AMADEUS 2 out of 3 years13 Sweden BvD - AMADEUS 2 out of 3 years14 UK BvD - AMADEUS 3 out of 5 years

15 USA S&P, Compustat 2 out of 3 years [both for comparables & tested party]

TP Assessment: Framework

TPO/ AO

CIT (Appeals)

Tax Tribunal

High Court

Supreme Court

Only legal issues

TPO/ AO

Panel for disputeresolution

Tax Tribunal

High Court

Supreme Court

Only legal issues

**effective 1st October, 2009

Panel to consist of 3 CITsDirections of Panel bindingupon TPO/ AODirections of Panel within9 months of referralTaxpayer can challengeruling before Tax Tribunal

Existing Proposed**

Tax Administration System

29

A Brief…..TP Assessments

Selection of cases

TP audits undertaken by a separate cell of the Indian Revenue authorities by designated Transfer Pricing Officers (‘TPO’). However, currently no separate appellate authority for TP.

The Assessing Officer (AO) may make reference to the TPO if he considers it necessary or expedient to do so [Section 92CA (1)] with previous approval of the Commissioner

CBDT had issued internal guidelines for selection of cases for TP scrutiny in cases where the aggregate value of international transactions exceeds Rs. 5 crores [Circular 3/2001]

The threshold limit for selection of cases for scrutiny : Rs. 15 Crores

Irrespective of the threshold limit instructed by CBDT : the cases may be picked up for scrutiny if the AO deems it fit or the AO may undertake the scrutiny on his own

Assessee

Approval for Reference

AO

Commissioner

TPO

Reference

Determination of ALP By TPO after hearing

TPO’s orderNotice u/s 92CA (2)

Show cause notice

Reply to SCN

Computation of Total Income In Conformity with ALP by

TPO

Order u/s 143 (2)

TP Audits : framework

AO to compute total income

in conformity with the ALP

determined by TPO

Can AO change the order by TPO?

Locations Savings

Revenue authorities seek high profit margins for service activities in India- target IT & ITES/ BPO units

Revenue authorities seek part of location savings to be in India

• Nature of services

• Value chain analysis- contribution of India efforts in the entire value chain

• Cherry picking of high profit companies for comparability

• In many cases, adjustments proposed at full cost plus 30% to 40%

• In certain recent cases, proposing to use Profit Split method

Need to carefully analyze TP for service operations in India

Marketing Intangibles

• Legal vs. economic ownership of intangibles

• Routine return for distribution operations vs. additional return for brand building

• Adjustment Scenarios

• Cost reimbursement imputed

• Purchase prices of goods adjusted

• Disallowance of “excessive” marketing spend

• Careful selection of comparables and economic analysis/ adjustments

• Maintain adequate documentation e.g. License Agreements, contracts etc.

• Robust documentation including FAR analysis and appropriate benchmarking

• Deemed IP transfer situations to be analysed carefully

30

Some target transactions

Revenue authorities have significantly increased focus/ scrutiny of complex transactions like:

• Transfer/ Licensing of intangibles; including royalties, technical know-how fees

– Benefit test

– Ongoing transfer of technology, documentation

– Resistance in loss situations

– Regulatory ceiling

• Management fees- benefit test and actual receipt of services

• High value/ IP generating services (value chain analysis)

Business restructurings, development of marketing intangibles, migration of functions/ risks, intangibles

Separate in-depth analysis and extensive documentation required for such transactions

Others…

Acceptability of Business strategies, loss situations

Transaction-wise analysis v/s Aggregation

Preference for CUP Method-TPO’s compare export price with

domestic price

Preference for Indian comparables

Third Party Information/ “Non public comparables”

Seek overseas pricing and profit information of Associated

Enterprises (AEs)

Case Study Case Study

Steps involved in a Transfer Pricing Analysis

Functional Analysis

Characterization of entities and Choice of Best Method

Determination of arm’s length price

Calculation of arm’s length range

Comparability adjustments

Search for uncontrolled comparables

Internal External

Quantitative and qualitative analysisReview of comparables

Review method

31

Case Study

ABC USAABC USA

ABC IndiaABC India

100 %100 %

ABC USA is engaged in the business of software development and is part of ABC Group

ABC India is a 100% subsidiary of ABC USA and is a dedicated software development center for ABC Group

Functional /Risk Analysis

ABC Group undertakes high end product conceptualisation, R&D, global marketing, distribution, sales and post-sales client support and owns all the IPRs

Initial coding and high end designing is done by ABC Group

ABC India undertakes the software development – coding, testing and maintenance

ABC India does not undertake any credit risk for the provision of services

ABC India does not bear any product liability risk which is borne by ABC Group

ABC India is paid in advance for contract software development services


ABC Group or

• ABC Group would have many other transactions with other Group affiliates and third parties

• ABC Group would own many intangibles / IPRs (entrepreneur)

ABC India

• ABC India is less complex entity out of the two transacting parties

– Accordingly, ABC India should be selected as the tested party for the analysis

Benchmarking/ Financial Analysis….Cont Selection of MAM

CUP

Hourly billing rate – is not readily available and varies from trade journal to trade journal for similar sort of services

Further there could be significant differences in functions performed and expertise of companies

Hence not applied in case of ABC India

32

Selection of MAM

RPM

ABC India is a service provider and not a distributor. Therefore, RPM is not considered the most appropriate method.

CPM

The cost attributable to providing services i.e. cost of services cannot be determined, unlike in case of manufacturing and trading operations. Accordingly, CPM is not considered the most appropriate method.

PSM

ABC India does not own non-routine intangibles and the routine operations of the Indian entity can be evaluated separately. Therefore, PSM is not considered the most appropriate method.

TNMM

Examines net profit margins relative to appropriate base which is less affected by transactional differences, more tolerant to functional differences.

Has been used for ABC India

Selection of MAM….Cont

Data to be used….

Which year’s data to be used

• Current year i.e. the year in which international transaction is entered into (contemporaneous) – not available

– Latest interim results for comparables

• Past year’s data which reveals facts that could have an influence on the determination of international transaction.

– One year data or

– Average of past two years

– The average of the past two years data could help in evening out any market variation or impact of business cycles.

Benchmarking/ Financial Analysis

Audited Financial ResultsAudited Financial Results

Databases

Prowess

Electronic database developed by Centre for Monitoring Indian Economy (‘CMIE’) Private Limited

Contains information on publicly-owned companies, generally obtained from documents filed with appropriate government agencies.

Database of large and medium sized companies in India

Provides a highly reliable database built by researchers at CMIE under a rigorous system of normalisation and validation.

CapitalinePlus

Further to broaden the search, another database ‘CapitalinePlus’, a widely recognised electronic corporate database developed and maintained by Capital Markets Publishers India Pvt. Ltd can also be used. It contains financial information of companies that include public, private, cooperative and joint sector companies, listed or otherwise.

Benchmarking/ Financial Analysis…Cont

33

Database

Industry Software developers

Elimination of companies with insufficient data

1. Must not engage in significant other business 2. Must not engage in significant related party transactions 3. Must not own valuable IPRs

1. Significant investment in NFA (NFA/ sales < 200%) 2. Insignificant R&D expenses as a percentage of sales < 3% 3. Companies having positive net worth

15 Companies

SEARCH SEARCH STRATEGYSTRATEGY

QuantitativeCriteria

AcceptedCompanies

QualitativeCriteria

Prowess

524 Companies

336 Companies

173 Companies

Sample search process

Accepted Companies’ ResultsCompany 2007 2008 Average

C1 24.50 26.20 25.35C2 22.20 24.10 23.15C3 18.50 20.60 19.55C4 15.70 17.40 16.55C5 15.80 17.50 16.65C6 15.20 16.80 16.00C7 14.50 13.80 14.15C8 14.20 14.20 14.20C9 14.10 12.80 13.45C10 13.40 15.10 14.25C11 13.10 12.90 13.00C12 12.90 13.60 13.25C13 12.80 12.70 12.75C14 11.40 11.20 11.30C15 10.10 8.70 9.40

Mean 15.23 15.84 15.53Upper Quartile 15.75 17.45 16.60

Median 14.20 14.20 14.20Lower Quartile 13.00 12.85 13.13


Result of the TP study

ABC India earns an OP/ TC of 13%.

Independent companies earn an OP/ TC of 15.53%.

Applying the 5% range permitted by law, ABC India’s OP/ TC satisfies the arm’s length standard prescribed under the Indian TP regulations.


Sample Search ProcessSample Search Process

34

Service Providers Reasons/ Explanation

Other Operating income/ Sales Capture service providers

Networth > 0 accepted Implies companies are in normal operation

NFA/ Sales Companies with significant asset base eliminated

R & D / Sales Identifying comparables who do not own intangibles

Sales turnover filter start up operations/ low level sales rejected

Manufacturing

Manufacturing Sales/ Sales Capture manufacturers

Select specific industry classifications Product/ Industry comparability

Networth > 0 accepted Implies companies are in normal operation

Sales turnover filter start up operations/ low level sales rejected

Search Filters used Search Filters used

Trading Reasons/ Explanations

Trading sales/ Sales Capture distributors

Networth >0 accepted Implies companies are in normal operation

Advertising & marketing sales Companies undertaking similar level of intangible development

Specific Industry classifications Product/ Industry comparability

Sales turnover filter Start up operations/ low level sales rejected

Sales Turnover Filter

Plant & Machinery/ Gross Fixed Assets

Leased Assets/ Gross Fixed Assets

Net Fixed Assets/ Sales

Depreciation/ Total Cost

Wages/ Total Cost

Filters – under debate with Tax Office

OECD GuidanceOECD Guidance

35

• Definition of Comparability analysis as per OECD Guidelines

“A comparison of a controlled transaction with an uncontrolled transaction or transaction. Controlled and uncontrolled transactions are comparable if none of the differences between the transactions could materially affect the factor being examined in the methodology (e.g. price or margin), or if reasonably accurate adjustments can be made to eliminate the material effects of any such differences.”

Comparability analysis OECD Discussion Draft on Comparability, 2006

The OECD discussion draft provides guidance on:

• Comparability analysis and a search for comparables – the perspective

• Internal comparables

• Sources of information

• Uncontrolled transactions – internal and external comparables

• 5 comparability factors

• Selecting / rejecting third party transactions and / or third party comparables

• Comparability adjustments

• Recommend explicit definition of internal and external comparables

• Preference for internal comparables over external

• Recommend more efforts for identification internal comparables and documenting the process

Internal Comparables

• Informal and confidential information on third parties

• Secret comparables discouraged

• Databases – commercial proprietary

• Tax authority access to proprietary databases

• Public information, eg. Industry analysis, broker reports, websites, etc

• Foreign source or non-domestic comparables

Sources of information

36

• Definition as per OECD Guidelines -

“Transactions between enterprises that are independent enterprises with respect to each other”

• Acknowledge difficulty of identifying uncontrolled transactions – for instance in certain highly vertically integrated industries e.g. automotive, pharmaceutical

• However, controlled transactions cannot be used to support transfer pricing outcomes

Uncontrolled Transactions

• Reconfirming importance of the five comparability factors

1. Characteristics of property / service

2. Functional analysis

3. Contractual terms

4. Economic circumstances

5. Business strategies

Comparability factors

Lists a set of common quantitative criteria used:

• Size criteria in terms of Sales, Assets or Number of Employees.

• Intangible-related criteria such as Net Value of Intangibles/Total Net Assets Value, or ratio of R&D/Sales where available: if tested party is a contract manufacturer which does not own significant manufacturing intangible nor participates in R&D.

• Criteria related to the importance of export sales (Foreign sales/total sales), when relevant.

• Criteria related to inventories in absolute or relative value: they can be used, for instance, to specifically search for manufacturers with no inventories

• Exclude comparables that are in peculiar situation such start-up companies, bankrupted companies, etc.

Qualitative Criteria:

• Geographic Markets

• Business Strategies

Economic Circumstances –Quantitative & Qualitative Criteria

Reiterates the need to identify internal comparables first

Reiterates the importance of comparability analysis and suggests steps

Provides an illustrative process

Acknowledges two approaches to identify external comparables – additive and deductive

Acknowledges area of judgement but expresses need to increase objectivity and transparency

Selecting / rejecting external comparables

Typical process for identifying comparable transactions

Searching information on comparable transactions requires a number of steps to be completed in a logical order:

Step 1: Broad based analysis (e.g. industry analysis, analysis of value-drivers, nature of the competition experienced and economic and regulatory factors).

Step 2 : Determination of years to be covered.

Step 3 : Review of the controlled transaction(s) under examination, in order to identify the relevant factors that will influence both the choice of the appropriate method(s) and the comparability analysis.

Step 4 : Review of existing internal comparables. Where necessary (i.e. where satisfactory internal comparables are not available), decision to look for external comparables.

Step 5: Determination of available sources of information on external comparables.

Step 6: Choice of the relevant transfer pricing method(s) and, depending on the method(s), definition of the relevant indicator (e.g. definition of the relevant net profit indicator in case of a TNMM).

Step 7: Identification of potential comparables: defining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in step 3

Step 8: Determination of and making comparability adjustments where appropriate.

Step 9: Interpretation and use of data collected, determination of the arm’s length remuneration.

Step 10: Implement support processes. Install review process to ensure adjustment for material changes and document these processes

Typical process for identifying comparable transactions

37

To be comparable means that:

None of the difference (if any) between the situations being compared could materially affect the condition being examined in the methodology OR

Reasonably accurate adjustments can be made to eliminate the effect of any such differences


Focus on the extent and reliability of the adjustments to the data used.

Acknowledges three types of comparability adjustments

1. Accounting

2. Working capital or asset intensity

3. Other (eg : geographical, contractual terms, equipment failure, etc.)


Only consider adjustments where they improve reliability of results

Consider quality of comparables – adjustments cannot make bad comparables good

Recommendation is to expand guidance and develop a common platform of principles and concepts eg. WCA

Comparability adjustments Comparability Adjustments

Indian TP authorities have expected limited risk captives to earn margins comparable to entrepreneurs; disregard of the risk and asset profile of the taxpayer vis-à-vis comparables

Indian authorities have in most cases accepted adjustment made to comparables primarily for working capital differences

No specific guidance for application/ acceptability of adjustments like

• Excess capacity adjustments

• Credit risk adjustments

• Adjustment for R&D activities/risks

• Adjustment for non-comparable functions – pass through costs etc.

• Other adjustments- such as ownership of intangibles etc.

Need to undertake and claim appropriate adjustments based on sound economic principles and commercial considerations

38

Two Day

Workshop

On

TRANSFER PRICING

39

Transfer Pricing Documentation

08 August 2009

08 August 2009 Transfer Pricing DocumentationPage 2

Contents• Section 92D • Rule 10D• Assessee’s responsibilities


Section 92D


► Section 92D of the Indian Income Tax Act provides the instructions for maintenance of documentation by persons entering into international transactions

92D. (1) Every person who has entered into an international transaction shall keep and maintain such information and document in respect thereof, as may be prescribed*.

(2) Without prejudice to the provisions contained in sub-section (1), the Board may prescribe the period for which the information and document shall be kept and maintained under that sub-section.

(3) The Assessing Officer or the Commissioner (Appeals) may, in the course of any proceeding under this Act, require any person who has entered into an international transaction to furnish any information or document in respect thereof, as may be prescribed under sub-section (1), within a period of thirty days from the date of receipt of a notice issued in this regard :

Provided that the Assessing Officer or the Commissioner (Appeals) may, on an application made by such person, extend the period of thirty days by a further period not exceeding thirty days.

* See Rule 10D

Section 92D

40


Rule 10D


A detailed list of mandatory documents to be maintained as part oftransfer pricing documentation are listed in Rule 10D(1) of the Rules.

Rule 10D

► Nature and terms (including price) of international transactions;

► Description of functions performed, risk assumed and assets employed (functional analysis);

► Records of economic and market analysis (economic analysis);

► Record of budgets, forecasts, financial estimates;

► Any other record of analysis (if, any) to evaluate comparability of international transaction with uncontrolled transaction(s);

► Description of method considered with reasons of rejection of other methods; and

► Details of transfer pricing adjustment(s) made (if, any)

► Ownership Structure;

► Profile of multinational group; and

► Business description/ Profile of industry

► Any other information e.g. data, documents like invoices, agreements, price related correspondence etc.

Entity Related

Price Related

Transaction Related


► Rule 10D(2) provides that detailed documentation (as prescribed in Rule 10D(1) is not required to be maintained by the taxpayer in case the aggregate value of all international transaction of the taxpayer is less than Rs. 1 Crore

► Rule 10D(3) provides the list of authentic documents which may be used to further support the documentation maintained in accordance with Rule 10D(1) ► official publications, reports, studies and data bases from the Government of the country of

residence of the associated enterprise, or of any other country;► reports of market research studies carried out and technical publications brought out by institutions

of national or international repute;► price publications including stock exchange and commodity market quotations;► published accounts and financial statements relating to the business affairs of the associated

enterprises;► agreements and contracts entered into with associated enterprises or with unrelated enterprises in

respect of transactions similar to the international transactions;► letters and other correspondence documenting any terms negotiated between the assessee and the

associated enterprise;► documents normally issued in connection with various transactions under the accounting practices

followed.

Rule 10D (Cont’d)


► Rule 10D(4) provides that the documentation to be maintained by the taxpayer should be ‘contemporaneous’ and should be maintained latest by the due date of filing the income-tax return

► Rules 10D(5) provides that the transfer pricing documentation should be maintained and kept by the taxpayer for a period of eight years from the end of the relevant assessment year

Rule 10D (Cont’d)

41


Assessee’s responsibilities


► There is one golden rule for the assessee. Document everything!► Most problems arise at the time of documentation if the assessee has not maintained

proper supplementary documents► All negotiation details, invoicing details, etc. should be maintained► Assessee should also undertake quarterly checks to ensure that arm’s length nature

of transactions is being maintained

Assessee’s responsibilities

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Two Day

Workshop

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TRANSFER PRICING

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Transfer Pricing Documentation: Practical Aspects

08 August 2009

08 August 2009 Transfer Pricing Documentation: Practical Aspects

Page 2

Contents• Introduction • Step by Step approach• Fact Finding• Functions Assets Risks Analysis• Economic Analysis• Case Study


Page 3

Introduction


Page 4

► The Transfer Pricing report is absolutely critical for the taxpayer► The transfer pricing report documents in detail the taxpayer’s business► The report will always be the starting point of transfer pricing audits► The robustness of the transfer pricing report determines strength of audit defense

► Key elements of TP report► Taxpayer’s business overview► Industry analysis► An analysis of the key Functions Assets & Risks involved► Economic analysis

Introduction

44


Page 5

► Detailed documentation of the taxpayer’s business and transactions► Should give the reader a complete understanding of the business of the

taxpayer and the intercompany transactions► Industry analysis should have an interface with the report► FAR analysis

► FAR analysis is the foundation of the economic analysis► It has also been the subject of recent judicial activity on transfer pricing

► Economic Analysis► Implications of FAR analysis on the economic analysis► Evaluation of data available► Determination of most appropriate method► Performing comparability search, if needed► Economic adjustments

Introduction (Cont’d)


Page 6

Step by step approach


Page 7

Fact gathering

Functional analysis

Economic analysis

Documentation/ Accountants report

Mapping of international transaction

Analysis of Functions, Risks, and Intangibles

Industry Analysis


Selection of Comparables

Calculation of arms length result

Report writing/ Accountants

report

Step by step approach to transfer pricing documentation

1

3

2

4


Page 8

Fact Finding• Investigation of facts about company profile• Transaction mapping• Understanding industry trends

45


Page 9

► Investigation of facts about company profile► Rule 10D information► Key markets of operations► Position in industry value chain► Current business model and organization structure ► Business strategy and plans affecting international transactions► Level of market at which taxpayer operates► Facilities undertaking various functions► Skill sets involved, technical qualifications of employees► Global TP Policy► TP Audit history

Fact finding


Page 10

► Transaction mapping► Prior year 3CEB and TP report► Related party schedule► Foreign currency transactions► Notes to accounts

► Understanding industry trends► Nature of industry (oligopolistic etc.)► Industry segmentation and structure► Demand drivers► Basis of competition (price, volume, contractual relationships)► Critical success factors► Significant changes (regulatory, technological)► Future outlook

Fact finding (cont’d)


Page 11

FAR Analysis• Understanding nature and terms of international transactions• Functions• Risks• Assets employed• Conclusion


Page 12

► Understanding international transactions► Review the inter-company agreements

► Identify contracting structure► Pricing policy with basis of defining policy► Collateral transactions

► Understand factual flow of transaction► Form versus substance

► Understand product / service life cycle ( input, process, output)► Capture transactions, contractual terms with unrelated parties (if any)

FAR AnalysisNature and Terms

46


Page 13

► Describe primary activity ( manufacturing, trading, services)► Identify key value driving functions► Requirement analysis / service specification► Understand supply chain flow► Conduct functional interviews in addition to questionnaires► Define function owner in the supply chain► Key functions:

► Strategic management functions► Product design & development► Quality control / assurance► Sales and distribution► Post-sales activities► General administrative functions

FAR AnalysisFunctions


Page 14

► Significant capital investment: Business risk► Dependence on few customers / vendors: Business risk► Costs of significant rework: Rework risk► Failure of R&D effort: R&D risk► Presence of excess capacity: Utilization risk ► Responsibility of warranty provision: Warranty risk► Impact of receivables: Credit risk ► Impact of technological changes: Obsolescence risk► Risk of damage to stored goods/products: Inventory risk► Exchange rate movements: Forex risk

FAR AnalysisRisks


Page 15

► Tangible► Capital equipment► Other fixed assets

► Intangibles► Technical know-how / data► Patents / copyrights► Presence of key employees► Use of unique / valuable methods, processes► Use of proprietary databases► Customer lists

FAR AnalysisAssets Employed


Page 16

► Entity characterization► Helps identify probable method to be applied► Helps identify kind of comparables to be examined

► Potential issues for consideration► Losses (if any) and reasons for same► PE implications► Creation of intangibles► Additional functions / risks requiring remuneration► Need for aggregation of transactions► Need for allocation of common costs► Location savings

FAR AnalysisConclusion

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Page 17

Economic Analysis• Internal comparable data• Determining tested party• Selection of most appropriate method• Search for comparables


Page 18

► Evaluate internal comparable data► Consider level of transactional data available► Document due diligence exercised to reject internal comparable prices /

transactions► Determine Tested Party:

► Least complex entity – based on FAR ► Availability of reliable data

► Evaluate most appropriate method► Based on data available and FAR analysis► Consider all methods based on relative strengths and weakness► Consider use of corroborative analysis

Economic AnalysisIdentification of method and tested party


Page 19

► Comparable search due diligence► Databases to be used► Comprehensive search criteria to ensure all possible avenues of identifying

comparable companies are covered► Quantitative and qualitative filters to be applied

► Annual report analysis for prospective comparables► Company’s description: Directors report. Management discussion► Risk Analysis : Management discussion► Qualifications, Financial solvency: Auditors report► Capital intensity, Debtor / Creditor position: Balance Sheet► Revenue and expense break-ups: P&L account► Related party transactions: notes to accounts► Segment reporting: notes to accounts► Litigation claims, extraordinary events: notes to accounts

Economic AnalysisComparable Search


Page 20

Case Study

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Two Day

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[Name of the company] Transfer Pricing Study Financial Year __________ Assessment Year ____________ Privileged and Confidential Draft Report Dated ____________

__________________________ Chartered Accountants

54

Table of Contents

S. No. CONTENTS PAGE NO.

1. Executive Summary 1.1 Introduction & Scope 1.2 Brief on the business 1.3 Economic Analysis 1.4 Conclusion

2. Overview 2.1 General 2.2 Profile of Group in which company operates 2.3 Profile of the company

3. Industry Overview

4. Applicability of Transfer Pricing Regulations

5. Functional Analysis 5.1 Objective 5.2 Analysis of Transactions

6. Economic Analysis

List of Appendices Appendix A : Scope and Limitation Appendix B : Indian Transfer Pricing Regulations Appendix C : Databases and their Limitations Appendix D : Indian Transfer Pricing Documentation Rules Appendix E : Results of Selected Comparable Uncontrolled Companies Margins Appendix F : Financial Information of the company to compute its margins

55

1. Executive Summary

1.1 Introduction

1.1.1 ____________has been engaged by __________________to review the transfer pricing arrangements for international transactions with its associated enterprises during the year ended March 31, ____on the terms set out in our engagement letter.

1.1.2 The objective of this study is to establish whether the international transactions between _____________and its associated enterprises adhere to the arm’s length principle, embodied in the Indian Transfer Pricing Regulations contained in Sections 92, 92A through 92F of the Indian Income-Tax Act, 1961, (the Act) read with Rules 10A to 10E of the Indian Income-Tax Rules, 1962 (the Rules)

1.2 Brief on the Business of the company

1.3 Economic Analysis

1.3.1 The Indian Regulations require the use of the ‘most appropriate’ transfer pricing

method which can be supported by uncontrolled comparables.

1.3.2 Company’s international transactions that need to be analysed from a transfer pricing perspective are ___________________________________

1.3.3 The summary of international transactions analysed in this report is tabulated

Below:

56

Table 1: Summary of Economic Analysis

1.4 Conclusion

1.4.1 The analysis provides evidence that both the pricing basis itself of the international transactions and the outcome of that pricing, support our view that the pricing of __________is consistent with the Arm’s Length standard under the Act and Rules.

1.4.2 It is important to note that the results of our transfer pricing analysis and our

recommendations are based on facts and financial data as of March 31, _______and pertain to the financial year ended March 31, _______. For the subsequent years the results would need to be altered so as to incorporate latest financial results and any changes in the functions performed and risks assumed. Also, we recommend that _______ review and update its transfer pricing policy to reflect changes in the market or changes in the nature of its related party transactions.

Nature of International Transaction

Most Appropriate

Method

__________________ (Tested Party)

Total Rupee value of

transaction

Price/Margin

57

2. Overview [About the company, shareholding pattern, associated enterprise and

transaction]

2.1 General

2.2 Profile of __________ Group

Will include the business, products etc of the multinational group

2.3 Profile of the company

About the company, business, products, locations etc

58

3 Industry Overview

3.1 Objective 3.1.1 As per the Indian Transfer Pricing Regulations, every person who has entered into

an international transaction shall keep and maintain inter alia, the information and documents giving a broad description of the industry in which the assessee operates. The Indian Regulations also prescribe that the comparability of an international transaction with an uncontrolled transaction shall be judged with reference to the conditions prevailing in the markets in which the respective parties to the transactions operate. Hence, for the purpose of the transfer pricing analysis, an overview of the industry is essential.

3.1.2 As a part of its business operations, __________operates in the

__________industry. Therefore, the performance of the company is interlinked to the performance of the said industry. The following section contains an analysis designed to provide an overview of the industry under which the comapny operates. An overview of the industry would assist in the understanding of the business risk faced by, operational characteristics of, and assets employed by the company in relation to other players in the industry.

3.2 Overview of Industry

3.3 Conclusion

59

4 Applicability of Transfer Pricing Regulations

In this section, the following issues are discussed:

Applicability of the Indian transfer pricing legislation to [Name of the

company]

Associated enterprises of [Name of the company]; and

International transactions of [Name of the company]

4.1 Applicability of the Indian transfer pricing legislation to [Name of the

company] With effect from 1st April 2001, section 92 (1) of the Income Tax Act provides

that any income arising from an international transaction shall be computed having regard to the arm’s length price.

Based on the provisions of section 92 B (1), an international transaction refers to a

transaction between two or more associated enterprises either or both of whom are non-residents which relates to inter alia purchase and sale of tangible property and services or provision of services, or lending or borrowing money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises, and shall include a mutual agreement or arrangement between two or more associated enterprises for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises..

Since _________ engages in international transactions with its associated

enterprises, the Indian Transfer Pricing regulations are applicable to the transactions between _________ and its associated enterprises.

4.2 Associated Enterprises of _________________________________

4.2.1 Section 92A(1) of the Act provides that associated enterprise in relation to another

enterprise means an enterprise:

a) which participates, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise; or

b) in respect of which one or more persons who participate, directly or indirectly,

or through one or more intermediaries, in its management or control or capital, are the same persons who participate, directly or indirectly, or through one or

60

more intermediaries, in the management or control or capital of the other enterprise.

4.2.2 Section 92A(2) specifically provides that two enterprises shall be deemed to be associated enterprises if, at any time during the previous year,

(a) one enterprise holds, directly or indirectly, shares carrying not less than

twenty-six per cent of the voting power in the other enterprise; or (b) any person or enterprise holds, directly or indirectly, shares carrying not less

than twenty-six per cent of the voting power in each of such enterprises; or 4.2.3 [How TP regulations applicable on company] 4.2.4 Keeping in view the above legislative provisions, associated enterprises with

which the company transacted during previous year are as listed below: 4.3 International transactions of [Name of the company]

The following international transactions undertaken during the year ended ____ have been reviewed in this report:

Name and address of associated enterprises

Country of tax residence

Ownership linkages

61

5. Functional Analysis 5.1 Objective 5.1.1 As per the India Regulations, every person who has entered into an international

transaction shall keep and maintain inter alia, a description of the functions performed, risk assumed and assets employed or to be employed by the assessee and the associated enterprises involved in the international transaction.

5.1.2 A functional analysis enables mapping of the economically relevant facts and

characteristics of transactions between associated enterprises with regard to their functions, assets and risks. Hence a functional analysis facilities characterization of the associated enterprises and assists in establishing a degree of comparability with similar transactions in uncontrolled conditions.

5.2 Functions Performed, assets employed and Risks assumed Summarised below is the analysis of functions performed, risk assumed and assets

utilized for each identified transaction: 5.2.1 Transaction 1

Details of Functioned performed and risk attained during the Transaction:

Function The company Associated Enterprise

XX XX XX XX XX XX XX XX XX XX

62

The Risks assumed by _________ with respect to export transactions are as follows:

Type of risks The company Associated enterprise

Market risk

Product liability risk

Inventory risk

Customer credit risk

Foreign exchange risk

Assets utilized:

Type of assets The company Associated enterprise

Plant and Machinery XX

Furniture & Fixtures, Office equipment XX

Human capital (personnel) XX

63

6. Economic Analysis

6.1 Based on the facts as presented in the functional analysis, ______ can be characterized as a __________, which assumes normal risks associated with carrying on such business, and employs routine tangible assets as mentioned in Functional Analysis above.

6.2 Selection of the Tested Party

6.3 Most Appropriate Method 6.3.1 The relevant provisions of Transfer Pricing under the Act requires the

computation of income from international transactions having regard to the arm’s length price. Section 92C(1) of the Act prescribes the following methods for the computation of arm’s length price.

Comparable Uncontrolled Price Method (CUP) Resale Price Method (RPM) Cost Plus Method (CPM) Profit Split Method (PSM) Transactional Net Margin Method (TNMM) Such other method as may be prescribed (no other method has been prescribed

till date)

The Act and Rules provide no priority of methods. Rather, the selection of the pricing method to be used to test the arm’s length character of a controlled transaction must be made under the ‘Most Appropriate Method Rule’. The ‘most appropriate method’ is that method which, under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm’s length result.

6.3.2 In determining the reliability of a method, the most important factors to be taken into account are (i) the degree of comparability between the controlled and uncontrolled transactions and (ii) the coverage and reliability of the available data. As per the Indian Regulations, other factors such as nature and class of international transactions, conditions prevailing in the markets, extent and reliability of adjustments that can be made, and extent and reliability of assumptions that may be required in applying the method, shall also be taken into account.

6.3.3 As the selection of the “most appropriate method” involves a test of relative

merits, a method that may not be perfect is not rejected unless some other method can be shown to be more reliable or provide a better estimate of an arm’s length result.

64

6.4 Selection of most appropriate method 6.4.1 Mentioned below is the analysis for arriving at the most appropriate method: (i) Comparable Uncontrolled Price Method

6.4.2 The Comparable Uncontrolled Price (CUP) Method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.

6.4.3 The standard of comparability under the CUP method is very high. Under the

CUP method, a transaction is considered comparable only if both the tangible property sold or service provided and the circumstances surrounding the controlled transaction are substantially the same as those of the uncontrolled transaction. Additional factors for determining comparability include: the quality of the product or service, the volume of sales or revenue, the level of the market, the geographic market in which the transaction takes place, and the date on which action takes place and alternative commercial arrangements realistically available to both parties. Any differences can be taken into account if adjustments can be made for such differences, and these adjustments have a reasonably ascertainable effect on the price. The extent and reliability of any such adjustments will affect the relative reliability of the analysis under the CUP method.

6.4.4 In practice, there are two types of comparable uncontrolled transactions. The first,

known as an “internal comparable,” is a transaction between one of the parties to the controlled transaction and an unrelated third party. The second, known as an “external comparable,” is a transaction between two unrelated third parties. Generally, specific details regarding internal comparables are more readily available to the parties engaged in the controlled transaction than details regarding external comparables.

6.4.5 Applicability of the CUP in respect of ____________ transactions

(ii) Resale Price Method

6.4.6 The Resale Price Method (RPM) evaluates the arm’s length nature of a controlled

transaction by reference to the gross profit margin realized in a comparable uncontrolled transaction. The RPM measures the value of functions performed and is ordinarily appropriate in cases involving the purchase and resale of tangible goods/services in which the buyer/reseller does not add substantial value to the goods by physically altering them or by using marketing intangibles.

6.4.7 The RPM begins with the price at which a product that has been purchased from

an associated enterprise is resold to an independent enterprise. The price (the resale price) is then reduced by an appropriate gross margin (the “resale price margin”) representing the amount out of which the reseller would seek to cover its

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selling and other operating expenses and, in the light of functions performed, makes an appropriate profit. Thus, under the RPM, comparability is primarily dependent upon the similarity of the functions performed and the risks assumed by the controlled and uncontrolled distributors, and are less dependent on he similarity of the tangible goods bought and resold.

6.4.8 [Applicability on the company]

(iii) Cost Plus Method

6.4.9 The Cost Plus Method (CPM) evaluates the arm’s length nature of a controlled transaction by reference to the gross profit mark up (i.e., gross profit divided by direct and indirect costs) that is realized in comparable uncontrolled transactions. The CPM is ordinarily appropriate in two situations: i) the provision of services to a related party; and ii) the manufacture of tangible goods that are sold to a related party.

6.4.10 The CPM begins with the costs incurred by the supplier of property (or services)

in a controlled transaction for property transferred or services provided to a related purchaser. An appropriate cost plus mark up is then added to this cost to make an appropriate profit in light of the functions performed and the market conditions. The amount so arrived at may be regarded as an arm’s length price of the original controlled transaction. Thus, under the CPM, comparability is primarily dependent upon the similarity of functions performed and risk assumed by the controlled and uncontrolled parties, and are less dependent on the similarity of the services provided or the goods produced. Reliability of the CPM may be adversely affected by factors such as cost structures, business, management efficiency and lack of reliable external comparable data.


(iv) Profit Split Method

6.4.12 In general, the Profit Split Method (PSM) evaluates whether the allocation of the combined profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined profit or loss. The profit split methods typically are applied where each party to the transaction under evaluation has significant intangible assets and/or the operations of the parties to the transaction are highly integrated and cannot be evaluated on a separate basis.

6.4.13 Although the Indian transfer pricing rules list only one PSM, they provide

guidance that the PSM can be applied by i) relying entirely on a contribution analysis; or ii) splitting the profits based on a residual analysis. Under the contribution analysis, the total profit earned by the parties to a controlled transaction is divided, based upon the relative contributions of the parties. The residual analysis allocates the combined operating profit or loss from the relevant business activity between the parties to the controlled transaction in two steps. First, a market return is provided to each party’s routine contributions. Second,

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any “residual” profit attributable to intangibles is divided among the parties to the controlled transaction under evaluation based upon the relative value of their non-routine contributions of intangible property.


(v) Transactional Net Margin Method

6.4.15 The Transactional Net Margin Method (TNMM) assesses the arm’s length character of transfer prices in a controlled transaction by testing the profit results of one participant in the transaction. The TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions that are appropriate to aggregate) in relation to the net margin that the same taxpayer earns in comparable uncontrolled transactions..

6.4.16 Under the TNMM, comparable transactions need to be only broadly similar.

Significant product diversity and some functional diversity between the controlled and uncontrolled parties are acceptable.

6.4.17 A strength of the TNMM is that net margins (e.g. return on assets, operating

income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP Method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but still earn broadly similar levels of net profits.

6.4.18 Although the TNMM theoretically is based on transactional data, it recognises

that no comparable data as such at transactional level is likely to exist. Further, in case the transactions are closely interlinked, the same can be aggregated under TNMM.


6.5 Conclusion of the Most Appropriate Method 6.5.1

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6.6 Search for uncontrolled comparables – Export transactions

6.6.1 The search for uncontrolled comparables for _________is detailed below: (i) Electronic Database 6.6.2 We searched one of the most widely recognized corporate databases, Prowess, to

identify potential uncontrolled comparables for ______transaction. 6.6.3 Prowess is developed by the center for monitoring Indian Economy (CMIE)

Private Limited, that contains financial information on publicity owned companies, generally obtained from documents filed with appropriate governmental agencies. Prowess is a database of large and medium sized companies in India (approximately over __________in number). Prowess is a highly reliable database built by researchers at CMIE under a rigorous system of normalization and validation.

6.6.4 For details about the database and its limitations please refer Appendix C. (ii) Selection of time period

6.6.5 As per the Indian Regulations, the data to be used in analyzing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into. However, data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of transfer prices in relation to the transactions being compared.

6.6.6 It may be noted that the current year data as stated in the Indian Regulations is

unrealistic as current year company accounts may not have been filed and entered on the database before the comparable company has filed their accounts with regulatory authorities. Further, quarterly financial data, where available, would be an abridged form and may be unaudited, which may distort comparability.

6.6.7 Further, the regulations require that the comparable data, as far as possible, should

be contemporaneous. Hence, a reasonable conclusion as regards arm’s length dealings between controlled parties could be obtained by using multiple year data or comparables. In this way, differences due to factors such as business or product life cycles can be effectively taken into account and comparability can be reliably determined. The approach of using multiple year data is consistent with the Indian Regulations and also the OECD Guidelines.

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(iii) Search Process 6.6.8

Summary of Search Process from Prowess

Criteria and reason for usage No. of Cos. passing

the CriterionTotal Universe of companies available in Prowess Companies engaged in the ______Business Companies engaged in manufacturing of ____________ not covered in initial search of companies in ___________business

Total initial selection of companies in similar business Elimination of companies with different product line Total Companies in the business of ___________ Elimination of companies with insufficient data (Note 1) Companies whose data is available Quantitative Criteria Elimination of companies whose turnover is less than 100 crore and more than 500 crore

Companies with negative net worth Accepted Companies

Note 1: Companies whose financial data for year 2007 or 2008 was not available in prowess.

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6.7 Application of Transactional Net Margin Method (i) Choice of a Profit Level Indicator (PLI) 6.7.1 The application of TNMM requires the selection of an appropriate Profit level

Indicator (PLI). The PLI measures the relationship between profits and either cost incurred, revenue earned or assets employed. A variety of PLI can be used. TNMM aims at arriving at the arm’s length operating profit (i.e. profit before financial and non-operating expenses).

6.7.2 Factors relevant to the selection of the appropriate PLI include the reliability of

the available data and the extent to which the PLI takes into account costs that would be considered by independent parties.

6.7.3 Return on total cost was selected to reliably measure the income of ________ that

it would have earned had it dealt with uncontrolled parties at arm’s length. The return on total cost or full cost mark up(operating profit/Operating cost (OP/OC) is similar to an operating margin indicator except that the denominator is cost-based rather than revenue based. This ratio is also easy to calculate and because the denominator includes both operating expenses and cost of goods sold, it is less susceptible (than the use of gross margins) to accounting and functional differences.

6.7.4 Based on the above considerations, we selected OP/OC as the acceptable PLI for

establishing the arm’s length operating results of _________ 6.8 Determination of Arm’s length results 6.8.1 The Indian regulations require that the Arm’s length price (ALP) in relation to an

international transaction shall be determined by any of the prescribed methods, being the most appropriate method.

6.8.2 All methods other than CUP are methods that enable determination of ALP on the

basis of respective margins earned by comparable uncontrolled companies. The relevant rules envisage determination of ALP by applying margins of each comparable company to the appropriate base of the enterprise. The regulations further provide that, where more than one price is determined by the most appropriate method, the ALP shall be taken to be the arithmetical mean of such prices, or at the option of the tax payer, a price which may vary from the arithmetical mean by an amount not exceeding +/-5% of such arithmetic mean, shall be the arm’s length price of the international transaction.

6.8.3 An alternative practical approach to arrive at such ALP could be to compute the

arithmetic means of margins of comparable companies and apply the same to the appropriate base of ______________ to determine the ALP.

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6.8.4 We have accordingly determined the arithmetic mean of the margins of the

comparable companies as seen in table below:

Description Number of companies =

_____

Mean

OP/OC

OP/Sales 6.8.5 The Indian regulations require that the arithmetic mean of the range of

comparables be used to determine the arm’s length price of intra-group transactions. The results of the analysis in the above table show that ______ is required to earn an OP/OC of ______ or more and OP/Sales of _______ to confirm that its export transactions with _____ group companies comply with the arm’s length standard prescribed by the Indian Regulations.

6.8.6 The OP/OC of _______ and OP/Sales of ______ (refer Appendix F ) earned by

______ for the financial year _______, is higher than the mean arm’s length OP/TC and OP/Sales earned by comparable companies.

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Appendix A : Scope and Limitations

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Appendix B : Indian Transfer Pricing Regulations Introduction The Indian Finance Act 2001 introduced a separate code on Transfer Pricing under Sections 92 to 92F of the Indian Income Tax Act, 1961 (“Act”). The regulations are largely based on OECD guidelines and describe the various transfer pricing methods, impose transfer pricing documentation requirements and contain penal provisions for non-compliance. The code deals with intra-group transactions and is applicable from April 1, 2001. Statutory Rules and Regulations i) Legislation The India Transfer Pricing Code prescribes that income arising from “international transactions” between “associated enterprises” should be computed having regard to the “arm’s length price”. It has been clarified that the allowance for any expense or interest arising from an international transaction shall also be determined having regard to the arm’s length price. The expressions “international transactions”, “associated enterprises” and “arm’s length price” have been defined by the new enactment. Further, where in an international transaction, two or more associated enterprises enter into a mutual agreement or arrangement for the allocation or apportionment of, or any contribution to, any cost or expense incurred or to be incurred in connection with a benefit, service or facility provided or to be provided to any one or more of such enterprises, the cost or expense allocated or apportioned to, or, as the case may be, contributed by, any such enterprise shall be determined having regard to the arm’s length price of such benefit, service or facility, as the case may be. It has been clarified that Indian Regulations will not be applicable where the application of arm’s length price results in a downward revision in the income chargeable to tax in India. In case where the income is enhanced as a result of transfer pricing adjustments, the same does not qualify for various tax concessions/ holidays prescribed by the Act. ii) “International Transactions” Section 92B of the Act defines the expression “international transaction” to mean a transaction between two (or more) associated enterprises involving sale, purchase or lease of tangible or intangible property, provision of services, cost sharing arrangements, lending/ borrowing of money, or any other transaction having a bearing on the profits, income, losses or assets of such enterprises. The associated enterprises could be either two non-residents or a resident and a non-resident. iii) Definition of “associated enterprises” The relationship of “Associated Enterprises” has been defined (by Section 92A) to cover direct/ indirect participation in the management, control or capital of an enterprise by another enterprise. It also covers situations where the same person (directly or indirectly) participates in the management, control or capital of both the enterprises.

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For the purpose of this definition, certain other specific parameters have been laid down, based on which two enterprises have been deemed to be associated enterprises. These include: a) direct/indirect holding of 26% or more voting power of an enterprise by the other

enterprise or by the same person in both the enterprises, b) advancing a loan by an enterprise that constitutes 51% or more of the total book value

of the assets of the borrowing enterprise, c) guaranteeing by an enterprise of 10% or more of total borrowings of the other

enterprise, d) appointment by an enterprise of more than 50% of board of directors or one or more

executive directors of an enterprise, or appointment of specified directorships of both enterprises by a same person,

e) complete dependence of an enterprise (for carrying on its business) on the intellectual

property licensed to it by the other enterprise, f) substantial purchase of raw material/ sale of manufactured goods by an enterprise to

the other enterprise at prices and conditions influenced by the latter, g) existence of any prescribed relationship of mutual interest (none prescribed till date)

In addition, where a transaction is entered into by the tax payer with an unrelated party and there exists a prior agreement in relation to such transaction between the unrelated party and the associated enterprise or the terms of such transaction are determined in substance between the unrelated party and the associated enterprise, the relevant transaction (between the tax payer and the unrelated party) will be deemed to be an associated enterprise transaction.

Further, a Permanent Establishment (PE) of a foreign enterprise also qualifies as an associated enterprise. Accordingly, transactions between a foreign enterprise and its Indian PE are covered within the ambit of this code. a. Burden of proof The onus of proving the arm’s length character of a transaction lies with the taxpayer. If during assessment proceedings, the tax authorities, on the basis of material or information or documents in their possession, are of the opinion that the arm’s length price was not applied, or adequate and correct documents/ information/ data were not maintained/ produced, the total income may be recomputed accordingly after giving the taxpayer an opportunity of being heard. b. Methodologies (& OECD issues) The expression “arm’s length price” is defined by Section 92F of the Act to mean a price that is applied/ is proposed to be applied to transactions between persons other than associated

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enterprises in uncontrolled conditions. The following methods have been prescribed (by Section 92C) for the determination of the arm’s length price: (a) Comparable Uncontrolled Price (CUP) Method

(i) the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;

(ii) such price is adjusted to account for differences, if any, between the international

transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market;

(iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm's length

price in respect of the property transferred or services provided in the international transaction;

(b) Resale Price Method (RPM)

(i) the price at which property purchased or services obtained by the enterprise from an associated enterprise is resold or are provided to an unrelated enterprise, is identified;

(ii) such resale price is reduced by the amount of a normal gross profit margin

accruing to the enterprise or to an unrelated enterprise from the purchase and resale of the same or similar property or from obtaining and providing the same or similar services, in a comparable uncontrolled transaction, or a number of such transactions;

(iii) the price so arrived at is further reduced by the expenses incurred by the

enterprise in connection with the purchase of property or obtaining of services;

(iv) the price so arrived at is adjusted to take into account the functional and other differences, including differences in accounting practices, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of gross profit margin in the open market;

(v) the adjusted price arrived at under sub-clause (iv) is taken to be an arm's length

price in respect of the purchase of the property or obtaining of the services by the enterprise from the associated enterprise.

(c) Cost Plus Method (CPM)

(i) the direct and indirect costs of production incurred by the enterprise in respect of property transferred or services provided to an associated enterprise, are determined;

(ii) the amount of a normal gross profit mark-up to such costs (computed according to the same accounting norms) arising from the transfer or provision of the same or

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similar property or services by the enterprise, or by an unrelated enterprise, in a comparable uncontrolled transaction, or a number of such transactions, is determined;

(iii) the normal gross profit mark-up referred to in sub-clause (ii) is adjusted to take into account the functional and other differences, if any, between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect such profit mark-up in the open market;

(iv) the costs referred to in sub-clause (i) are increased by the adjusted profit mark-up arrived at under sub-clause (iii);

(v) the sum so arrived at is taken to be an arm's length price in relation to the supply of the property or provision of services by the enterprise.

(d) Profit Split Method (PSM)

The Indian Regulations define PSM, which may be applicable mainly in international transactions involving transfer of unique intangibles or in multiple international transactions which are so interrelated that they cannot be evaluated separately for the purpose of determining the arm's length price of any one transaction, as follows:

(i) the combined net profit of the associated enterprises arising from the international transaction in which they are engaged, is determined;

(ii) the relative contribution made by each of the associated enterprises to the earning of such combined net profit, is then evaluated on the basis of the functions performed, assets employed or to be employed and risks assumed by each enterprise and on the basis of reliable external market data which indicates how such contribution would be evaluated by unrelated enterprises performing comparable functions in similar circumstances;

(iii) the combined net profit is then split amongst the enterprises in proportion to their relative contributions, as evaluated under sub-clause (ii);

(iv) the profit thus apportioned to the assessee is taken into account to arrive at an arm's length price in relation to the international transaction:

Provided that the combined net profit referred to in sub-clause (i) may, in the first instance, be partially allocated to each enterprise so as to provide it with a basic return appropriate for the type of international transaction in which it is engaged, with reference to market returns achieved for similar types of transactions by independent enterprises, and thereafter, the residual net profit remaining after such allocation may be split amongst the enterprises in proportion to their relative contribution in the manner specified under sub-clauses (ii) and (iii), and in such a case the aggregate of the net profit allocated to the enterprise in the first instance together with the residual net profit apportioned to that enterprise on the basis of its relative contribution shall be taken to be the net profit arising to that enterprise from the international transaction.

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(e) Transactional Net Margin Method (TNMM)

(i) the net profit margin realised by the enterprise from an international transaction entered into with an associated enterprise is computed in relation to costs incurred or sales effected or assets employed or to be employed by the enterprise or having regard to any other relevant base;

(ii) the net profit margin realised by the enterprise or by an unrelated enterprise from a comparable uncontrolled transaction or a number of such transactions is computed having regard to the same base;

(iii) the net profit margin referred to in sub-clause (ii) arising in comparable uncontrolled transactions is adjusted to take into account the differences, if any, between the inter national transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions, which could materially affect the amount of net profit margin in the open market;

(iv) the net profit margin realised by the enterprise and referred to in sub-clause (i) is established to be the same as the net profit margin referred to in sub-clause (iii);

(v) the net profit margin thus established is then taken into account to arrive at an arm's length price in relation to the international transaction.

(f) such other method as may be prescribed (no method has been prescribed till date) The Regulations provide no priority of methods. Rather, the selection of the pricing method to be used to test the arm’s length character of a controlled transaction must be made under the ‘Most Appropriate Method Rule’. The ‘most appropriate method’ is that method which, under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm’s length result.

The legislation requires a taxpayer to determine an arm’s length “price” for all international transactions. It further provides that where more than one arm’s length price may be determined by applying the most appropriate Transfer Pricing method, the arithmetic mean of such prices shall be the arm’s length price of the international transaction. Accordingly, the Indian legislation does not recognise the concept of “arm’s length range”, but requires the determination of a single arm’s length “price”. However, the India Finance Act 2002 has extended some flexibility to taxpayers to adopt any price falling within (+/-) 5% of the arithmetic mean of uncontrolled prices. In determining the reliability of a method, the two most important factors to be taken into account are (i) the degree of comparability between the controlled and uncontrolled transactions and (ii) the coverage and reliability of the available data. As per the Indian Regulations, other factors such as nature and class of international transactions, conditions prevailing in the markets, extent and reliability of adjustments that can be made, and extent and reliability of assumptions that may be required in applying the method, shall also be taken into account.

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Documentation Requirements i. Documentation Taxpayers are required to maintain the prescribed information and documentation as part of their transfer pricing documentation to demonstrate that the pricing policy complies with the arm’s length principle. Documentation should be kept and maintained for nine years from the end of the relevant tax year. ii. Comparable Data As per the Indian Regulations, the data to be used in analysing the comparability of an uncontrolled transaction with an international transaction shall be the data relating to the financial year in which the international transaction has been entered into. However, data relating to a period not being more than two years prior to such financial year may also be considered if such data reveals facts which could have an influence on the determination of the transfer price in relation to the transactions being compared. Accountant’s report It is mandatory to obtain an independent accountant’s report in respect of all international transactions between associated enterprises and furnish the report with the income tax return. The form of the report has been prescribed. The report requires the accountant to give an opinion on the proper maintenance of prescribed documents and information by the taxpayer. Further, the accountant is required to certify the correctness of an extensive list of prescribed particulars. Tax Penalties The following penalties have been prescribed for default in compliance with the provisions of the transfer pricing code: (a) For failure to maintain prescribed information/ documents: 2% of transaction value. (b) For failure to furnish information/ documents during audit: 2% of transaction value. (c) For adjustment to taxpayer’s income: 100% to 300% of tax on adjustment amount. (d) For failure to furnish accountant’s report: INR 100,000.

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Appendix C : Databases and their Limitations The search for comparable uncontrolled companies relied on financial information primarily on electronic database namely ‘Prowess’ developed by Centre for Monitoring Indian Economy (CMIE)Private Limited, that contains information on publicly-owned companies, generally obtained from documents filed with appropriate government agencies. Prowess is a database of large and medium sized companies in India, (over 10,000 in number) encapsulated in software developed by CMIE to facilitate financial, industrial and investment analysis. Prowess provides a highly reliable database built by researchers at CMIE under a rigorous system of normalisation and validation. The compilers of these databases have standardised / normalized the data through reclassification of certain heads of income and expenses. The financial data is updated in Prowess as and when the data is available with the database providers. Hence, in every update, the latest financial data for some companies would get updated. Our work on databases have been subject to the following limitations:

a) We have not tested the validity of the search engine employed by the databases; b) We have not in general, examined the published financial statements of the

companies in our comparable set, nor have we otherwise enquired into the nature of their circumstances, activities or results;

c) The financial data provided in the databases is not complete in all respects for all

companies and the data is classified and treated in a manner that is unique to Prowess. d) Accordingly the data fields provided by Prowess have been used by us to define

various financial terms laid down in the Indian Transfer Pricing Rules 10A to 10E (‘Indian TP Rules). The Indian accounting standards and Generally Accepted Accounting Practices / Principles followed in India do not specifically define certain financial terms that have been laid down in the Indian TP Rules and those that have been coined by us for the purposes of this benchmarking exercise (e.g. gross profit, direct and indirect costs of production, operating / net profit, value adding expenses etc.) Also, they are typically not represented in annual accounts of companies and the level of necessary disaggregated information required to define such financial terms are also not typically available in annual accounts. We believe that our definitions are reasonable and appropriate in view of general accounting and cost accounting concepts and are in compliance with the underlying intent of Section 92 to 92F of the Indian Income-tax Act, 1961 read with the Indian TP Rules.

e) We have relied on the basis used by Prowess for classifying the industry / sub-

industry types.

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Appendix D : Indian Transfer Pricing Documentation Rules

Indian Transfer Pricing Documentation Rules 10D. Information and documents to be kept and maintained under section 92D Every person who has entered into an international transaction shall keep and maintain the following information and documents, namely: (a) a description of the ownership structure of the assessee enterprise with details of shares or other ownership interest held therein by other enterprises; (b) a profile of the multinational group of which the assessee enterprise is a part along with the name, address, legal status and country of tax residence of each of the enterprises comprised in the Group with whom international transactions have been entered into by the assessee, and ownership linkages among them; (c) a broad description of the business of the assessee and the industry in which the assessee operates, and of the business of the associated enterprises with whom the assessee has transacted; (d) the nature and terms (including prices) of international transactions entered into with each associated enterprise, details of property transferred or services provided and the quantum and the value of each such transaction or class of such transaction; (e) a description of the functions performed, risks assumed and assets employed or to be employed by the assessee and by the associated enterprises involved in the international transaction; (f) a record of the economic and market analyses, forecasts, budgets or any other financial estimates prepared by the assessee for the business as a whole and for each division or product separately, which may have a bearing on the international transactions entered into by the assessee; (g) a record of uncontrolled transactions taken into account for analysing their comparability with the international transactions entered into, including a record of the nature, terms and conditions relating to any uncontrolled transaction with third parties which may be of relevance to the pricing of the international transactions; (h) a record of the analysis performed to evaluate comparability of uncontrolled transactions with the relevant international transaction; (i) a description of the methods considered for determining the arm’s length price in relation to each international transaction or class of transaction, the method selected as the most appropriate method along with explanations as to why such method was so selected, and how such method was applied in each case;

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(j) a record of the actual working carried out for determining the arm’s length price, including details of the comparable data and financial information used in applying the most appropriate method, and adjustments, if any, which were made to account for differences between the international transaction and the comparable uncontrolled transactions, or between the enterprises entering into such transactions; (k) the assumptions, policies and price negotiations, if any, which have critically affected the determination of the arm’s length price; (l) details of the adjustments, if any, made to transfer prices to align them with arm’s length prices determined under these rules and consequent adjustment made to the total income for tax purposes; (m) any other information, data or document, including information or data relating to the associated enterprise, which may be relevant for determination of the arm’s length price.

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Appendix E : Results of Selected Comparable Uncontrolled Companies Margins

Company Name 2007 2008 2007 2008

OP/Sales

% OP/Sales

% MEAN OP/ OC% OP/ OC% Mean

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Appendix F : Financial Information of the company to compute its margins

____________________________________________

Year ended

March 31, _____ (Amount In Rs)

INCOME Sales Sales & services to other units Other income Total EXPENDITURE Raw material consumed and purchase of finished goods Manufacturing expenses Personnel expenses Administrative and other expenses Interest and financial charges Selling and distribution expenses (Increase)/Decrease in work in process and finished stock Depreciation & amortisation Prior period items Total Profit for the year before tax Non-operating expense Operating Cost Operating Profit OP/sales OP/OC

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Two Day

Workshop

On

TRANSFER PRICING

84

Transfer Pricing in IndiaRecent Case laws and developments

08 August 2009

08 August 2009 Transfer Pricing Case LawsPage 2

Contents• Transfer Pricing rulings so far• Key Rulings


Transfer Pricing Rulings so far


Transfer pricing rulings so far

► Aztec Software & Technology – 12 July 2007(2007-TIOL-210-ITAT-BANG) (294 ITR 32) (107 ITD 141) (109 TTJ 892)

► Mentor Graphics Private Limited – 2 November 2007(2007-TIOL-382-ITAT-DEL) (109 ITD 101) (112 TTJ 408) (2007 18 SOT 76)

► I Gate Global Solutions Limited – 27 November 2007(112 TTJ 1002)

► Ranbaxy Laboratories Limited – 22 January 2008(2008-TIOL-75-ITAT-DEL) (299 ITR 175) (110 ITD 428)

► Cargill India Private Limited – 15 February 2008(2008-TIOL-94-ITAT-DEL) (300 ITR 223) (110 ITD 616) (116 TTJ 1)

► Development Consultants Private Limited – 4 April 2008(2008-TIOL-150-ITAT-KOL) (115 TTJ 577)

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Transfer pricing rulings (cont’d.)

► Star India Private Limited – 28 May 2008(2008-TIOL-426-ITAT-MUM)

► Egain Communication Private Limited – 10 June 2008(2008-TIOL-282-ITAT-PUNE) (118 TTJ 354)

► Sony India Private Limited – 23 September 2008(2008-TIOL-439-ITAT-DEL) (114 ITD 448) (118 TTJ 865)

► Philips Software Center Private Limited – 26 September 2008(2008-TIOL-471-ITAT-BANG) (119 TTJ 721) (2008 26 SOT 226)

► Essar Shipping Private Limited – 21 November 2008(2008-TIOL-652-ITAT-MUM) (2009 27 SOT 409)

► Coca Cola India Inc. – 17 December 2008(2008-TIOL-656-HC-P&H) (309 ITR 194)


Transfer pricing rulings (cont’d.)

► Moser Baer India Ltd. and Others – 19 December 2008(2008-TIOL-647-HC-DEL) (221 CTR 97)

► UCB India Private Limited – 2 February 2009(2009-TIOL-184-ITAT-MUM)

► Honeywell Automations India Limited – 10 February 2009(2009-TIOL-104-ITAT-PUNE)

► SDRC India Private Limited – 6 March 2009(2009-TIOL-185-ITAT-DEL)

► Skoda Auto India Private Limited – 12 March 2009(2009-TIOL-214-ITAT-PUNE)


Jurisdiction-wise rulings

Issuing authorities

Delhi ITAT

BengaluruITAT

Delhi HC

P&H HC

Kolkata ITAT

Pune ITAT

Mumbai ITAT

3

1

5

1

3

1

3


Industry focus

Industryfocus

SoftwareServices\ ITES

AutomotiveIndustry

Shipping ServicesTrading

Engineering Services

PharmaceuticalsIndustry

Other Industries

2

26

11

1

6

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Key judicial pronouncements


Key judicial pronouncements –cases covered► Aztec Software & Technology Services Ltd.

(2009-TIOL-170-HC-KAR) (Karnataka High Court)

► Mentor Graphics Private Limited (2007-TIOL-382-ITAT-DEL)

► Egain Communication Private Limited (2008-TIOL-282-ITAT-PUNE)

► Sony India Pvt. Ltd. (114 ITD 448) (Del Tribunal)

► Philips Software Centre Pvt. Ltd. (2009-TIOL-123-HC-KAR) (Karnataka High Court)

► Coca Cola India Inc. v ACIT (309 ITR 194) (Punjab & Haryana HC)

► UCB India Private Limited v ACIT(2009-TIOL-184-ITAT-MUM)

► Skoda Auto India Pvt. Ltd. v ACIT(2009-TIOL-214-ITAT-PUNE)


Ruling 1 –Aztec Software & Technology Services Ltd. (2009-TIOL-170-HC-KAR) (Karnataka High Court)


Ruling by the Tribunal

► Assessing Officer not obligated to demonstrate tax avoidance before invoking Transfer Pricing provisions

► No requirement for Assessing Officer to satisfy himself on the incorrectness of arm’s length price determined by the taxpayer before making a reference to the Transfer Pricing Officer

► Internal instruction of CBDT binding on Assessing Officers and legally valid► Transfer Pricing Officer’s order not binding on the Assessing Officer

► Subsequent amendment made by the Finance Act, 2007 requiring the Assessing Officer to pass orders in conformity with the arm’s length price determined by the Transfer Pricing Officer

► Transfer Pricing to apply even in case of tax exempt units► Reference can be made to the OECD Transfer Pricing Guidelines for

resolving disputes

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Ruling by the High Court

► The Karnataka High Court has admitted the appeal of the Department against the order of Tribunal (5 Member Special Bench) and stayed the operation of the order of Tribunal

► The High Court admitted the appeal to formulate the substantial question of law arising out of the order of the Tribunal

Post the decisions of Karnataka High Court in the case of Philips Software and Aztec Software, most of the transfer pricing issues

are now open for interpretation


Ruling 2 –Mentor Graphics Private Limited(2007-TIOL-382-ITAT-DEL) (Delhi Tribunal)


Facts of the Case

Background

Mentor Graphics (Ind Co) is engaged in providing software development services to its parent company in USA (US Co) at US$ 180 per man-day

TP Documentation prepared by Indian Company in accordance with Indian Transfer Pricing Rules for the relevant tax year (2001-02):

Selected Transactional Net Margin Method (“TNMM”) as the most appropriate method for determining arm’s length price (ALP)

Ind Co earned operating margin of 6.99% on total costs and was within the permissible range of the margins of the comparable companies

Order of the TPO/AO / CIT

Transfer Pricing Officer (TPO) rejected the TP analysis undertaken by Ind Co and determined the arm’s length margin to be 24.53%

TP adjustment was upheld by Commissioner (Appeals)


► Observations on Economic Analysis

Need for adopting judicious approach while performing comparability analysis taking into all facts and circumstances

Characteristics of the controlled transaction – an important and critical factor for comparability analysis

Functional and risk analysis of uncontrolled transactions (in addition to turnover and operating profit) to be carried out and compared with characteristics of the controlled transaction

Recognized the fundamental principle of economics i.e., the greater the risk, the greater the expected return

Quantitative adjustments required in case of material and significant differences

Comparables to be rejected if differences between the companies is so material that adjustment is not possible

Reliance on OECD TP guidelines and U.S. Court decision (DuPont de Nemours & Co. v. United States (1979) 608 F2nd 608) to highlight importance of comparability


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► Observations on TPO’s Analysis

No consideration was given by TPO to the transfer pricing principles while judging comparability

Analysis was not consistent with the Indian TP rules nor in conformity with OECD Guidelines

Conclusions on appropriateness of comparables based on certain presumptions and not backed by complete facts

Similarity of functions & risks need to be considered even while applying TNMM, despite OECD guidelines suggesting that TNMM is more tolerant to minor functional/ risk differences

Wide difference in operating margins of comparables selected by TPO points that analysis is faulty and warranted a more detailed analysis

New comparable search undertaken by TPO warranted only if the comparables selected by taxpayer were insufficient or had other deficiencies, which was not adequately established by TPO

Ruling by the Tribunal (cont’d)


Key inferences/observations

TPO approach was not consistent with TP rules/ OECD guidelines

Approach adopted by TPO suffered from severe defects which materially impacted determination of arm’s length price

The selection process of comparables by taxpayer was based on proper screening which gave due consideration for functions and risks

Arm’s length Price

If more than one price is determined as the arm’s length price, any data point on the range can be regarded as meeting the arm’s length standard

Arm’s length requirement satisfied as long as margin earned by taxpayer is more than the margin earned by any of the comparable companies


Ruling 3 –Egain Communications Private Limited (2008-TIOL-282-ITAT-PUNE) (Pune Tribunal)


► The ITAT relied on OECD guidelines, US Regulations and the judgment passed in case of Mentor Graphics and supported that adjustment made on account of difference in FAR should be appropriately considered

► The degree comparability between the tested party and identifiedcomparable companies with the parameters like nature or line of business, product or service market, composition of assets employed size and scope of operations etc to be given due consideration

► The TPO should provide the sufficient reasons for considering comparable companies other than comparable companies selected by the Assessee

► Due consideration to be given to the turnover of the Assessee for the application of turnover filter for selection of comparable companies

► Adjustment made by Assessee on account of depreciation is appropriate and is in accordance with the law


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► Re-affirmed the fact that due consideration is required to be given to FAR analysis of the tax payer

► Adjustment(s) can be made to account for the difference in FAR analysis of the tested party and that of the comparable companies

Key Inferences/observations


Ruling 4 –Sony India Pvt. Ltd. *(114 ITD 448) (Delhi Tribunal)

* Represented by EY Litigation Team


Facts of the case

► I Co is a WOS of Japanese company► I Co is primarily engaged in assembly

and distribution of color televisions and audio products

► I Co is also engaged in provision of advisory services and software development services to its AEs

► I Co did not own any intangibles and did not invest in research and development (‘R&D’)

► I Co conducted an analysis using foreign AEs from whom the components were imported as ‘tested parties’ by relying upon the results derived by adopting TNMM

Advisory servicesand software developmentservices

Overseas AEs

Outside India

In India

Indian Company‘I Co’

Import of TV and audio products for assembly and sale in India and import of other high-end electronic goods, recordable media tapes, etc. for distribution and import of spare parts


Facts of the case (cont’d.)

► Similarly, TNMM was employed to justify the transactions related to advisory services and software development services

► TPO accepted the ALP determined by the I Co in respect of the software development services. However, TP analysis for other international transactions was rejected

► TPO of the view that I Co should not have used foreign AE’s as tested parties► I Co accordingly furnished revised TP analysis► TPO challenged the revised analysis on several grounds and determined a

revised ALP► On appeal before the CIT(A), certain TP adjustments undertaken by the

AO/TPO were upheld

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Issues before the Tribunal

► Selection of comparable data► Arm’s length range► Whether adjustments needs to be made to the margins of comparables to

eliminate difference on account of different functions, assets and risks► Whether reimbursement of advertisement expenses by AEs under an

arrangement can be considered for computation of taxpayer’s profitability► Whether other credits appearing in the profit and loss account can be

considered for computation of taxpayer’s profitability



► Selection of comparable data► Loss making companies cannot be excluded from the list of comparables, as

incurrence of loss is a normal part of business. However, where losses are made consistently and there are other peculiar company specific factors, the company may not be a comparable

► Undertaking functional analysis is of high significance. If reasonable accurate adjustment cannot be made to eliminate the material effect of differences between the transactions/entities, then such uncontrolled comparables may have to be rejected

► Companies whose related party transactions as a percentage of revenue do not exceed 10-15 percent can be considered as comparable. For this purpose, what is to be seen is the impact of related party transaction vis-à-vis sales

► Reference also made to OECD guidelines and US TP regulations


Ruling by the Tribunal (cont’d.)

► Arms length range► Reference was drawn to the decision of Kolkata Tribunal in the case of

Development Consultants Private Limited► Proviso to section 92C(2) provides that in the event more than one ALP is

determined, the ALP would be the mean of such prices or at the option of the Appellant, a price which varies by 5% of such mean

► Proviso clearly establishes that it is at the option of the taxpayer to avail this benefit► Option is intended to provide marginal benefit at the choice of the taxpayer► Contention that the marginal benefit is not available in cases where the price shown

by the taxpayer exceeds 5% of the ALP is not acceptable► Proviso is intended to give marginal relief to all taxpayers as determination of ALP

is not an exact science but is an approximation



► Adjustments needs to be made to margins of the comparables to eliminate differences on account of different functions, assets and risks ► Adjustments to the comparables for difference arising on account of working

capital, import duties paid, R&D/intangibles, risks are acceptable► Not an easy job to evaluate the differences for each of the factors and held that the

“Ad-Hoc” adjustment of 20% granted by TPO for these factors was fair andreasonable

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► Advertisement expenses reimbursed by AEs considered for computation of taxpayer’s profitability► Taxpayer as a market penetration strategy incurred advertisement expenses in

India► Portion of such expenditure was reimbursed by AEs► Taxpayer considered the reimbursement as reducing its operating expense► TPO ‘re-characterized’ the reimbursement as a form of loan or equity from AE and

did not consider it as an operating item for the analysis► Under the fiscal statutes, actual transaction, as entered into between the parties,

has to be considered and the authorities have no right to re-write the transaction unless it is held that it is sham or entered into by the parties in bad faith to avoid and evade taxes

► Genuineness or bona-fide of the agreement has not been doubted or disputed at any stage of the proceeding

► Reference also made to OECD guidelines and US TP regulations



► Amounts credited to the profit and loss account in respect of the following items which were accepted by the Tribunal as forming part of operating income► Provision and balances written off► Interest received from customers for delayed payment► Insurance claim received by the taxpayer


Key inferences/observations

► Cost sharing/allocation need to be carefully structured and evaluated from an economic analysis viewpoints and should also be properly documented. Legal agreements capturing business realties are a critical of any taxpayer’s TP analysis

► Provides guidance on:► selection of comparable data► steps for determining ALP► application of arms length range

► Ruling has continued the approach adopted by the Indian Tax Tribunals in earlier decisions that OECD TP guidelines and foreign country TP regulations can be relied upon as an aid in interpreting TP rules, where appropriate


Key inferences/observations (cont’d.)

► Useful precedent for Indian affiliates of multi-national groups, who incur significant sales promotion and marketing expenditure, a portion of which is reimbursed by foreign affiliate

► Ruling also reaffirms the EY position, wherein provision written backs, insurance claims and interest received from customers is considered as ‘operating income’

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Ruling 5 –Philips Software Centre Pvt. Ltd.(2009-TIOL-123-HC-KAR) (Karnataka High Court)



► AO/TPO to demonstrate tax avoidance before applying TP provisions or making adjustments for taxpayers eligible for tax holiday

► AO/TPO to prove that at least one of the four conditions set out in Section 92C(3) have been satisfied and communicate the same to the taxpayer, before carrying out fresh analysis

► TPO’s analysis not in conformity with the provisions of Rule 10B(4) and 10D(4)

► Companies with even a single rupee of transactions with AE cannot be considered as comparables

► Adjustments needs to be made to margins of the comparables to eliminate differences on account of different functions, assets and risks

► Normalizing margins of super profit making companies, a concept nowhere covered in Indian TP provisions

► Benefit of 5% standard deduction, under proviso to Section 92C(2), at the option of the taxpayer



► The Karnataka High Court has admitted the appeal of the Department against the Tribunal order for all the issues involved and stayed the order of Tribunal

► The High Court admitted the appeal in respect of the following substantial question of law:► Whether the TP provisions cannot be invoked and applied in the case where the

provisions of section 10A of the Act where income is exempt, is availed of by the Appellant?

► Whether the Appellant was justified in using earlier year data in comparability analysis?

► Whether section 92C(2) of the Act provides for a standard deduction of 5% in all TP cases?

► Whether a flat comparability adjustment for working capital and risk can be made ignoring the quality, data, purpose and reliability of adjustment?

► Whether companies with even a single rupee related party transaction should not be selected as comparables?


Ruling 6 –Coca Cola India Inc. (309 ITR 194) (Punjab and Haryana HC)

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Facts of the case

► Coca Cola India Inc (F Co) is incorporated under the laws of USA and is a foreign company with in the meaning of section 2(23A) of the Act

► F Co has a branch office in India to render services to the group companies

► F Co has entered into service agreement with Britco Foods Pvt. Ltd. to advise, monitor and co-ordinate the activities of bottlers

► In consideration of which F Co receives fee at actual cost plus 5%

Coca Cola India Inc.

(F Co)

Outside India

In India

Branch Office Britco

Payment for services



► As per order dated 7.2.2005 u/s 92 CA (3) for the AY 2002-03, passed by the TPO, the profit declared by the petitioner was abnormally low, on account of which ALP had been fixed. On that account, the income of the Appellant had escaped assessment

► On the basis of the above, the AO issued notice u/s 148 to F Co for AY1998-99 on 30 March 2005

► F Co sought reasons for the proposed reassessment► The reasons indicated that the AO referred to Section 92 of the Act, which

enables the AO to determine profits which may reasonably deemed to have been derived, when less than ordinary profits are shown to have been derived by a resident.


Issues before the High Court

► Whether inapplicability of unamended provisions of Section 92 of the Act (as it stood prior to 1.4.2002) to the petitioner created a bar to reassessment of escaped income of the petitioner?

► Whether order passed by TPO after 1.4.2002 could be one of the reasons for reassessment for period prior to introduction of amended Chapter X in the Act?

► Whether provisions of Chapter X are attracted when both the parties to a transaction are subject to tax in India, in absence of allegation of transfer of profits out of India or evasion of tax?

► Whether opportunity of being heard is required before referring the matter of determination of ALP to TPO?



► Section 147 of the Act is not in any manner controlled by Section 92 of the Act nor there is any limit to consideration of any material having nexus with the opinion on the issue of escapement of assessment of income

► Requirement of Section 147 of the Act is fulfilled if the AO can legitimately form an opinion that income chargeable to tax has escaped assessment. The order of TPO for subsequent year can certainly have nexus for reaching the conclusion that income has been incorrectly assessed or has escaped assessment

► There is no ambiguity or absurd consequences of application of Chapter X to persons who are subject to jurisdiction of taxing authorities in India and for invoking TP provisions, there is no requirement to establish transfer of profits outside India or evasion of tax

► The only condition precedent for invoking provisions of Chapter X is that there should be income arising from international transaction and such income has to be computed having regard to ALP

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Ruling by the High Court (cont’d.)

► The contention that according to the permission granted by the Reserve Bank of India under the FERA, the Appellant cannot charge more than particular price, can also not control the provisions of the Act, which provides for taxing the income as per the said provision or computation of income, having regard to ALP in any international transaction, as defined

► There is no requirement to give a hearing at the stage of making reference u/s 92CA of the Act because the decision to make a reference does not visit the Appellant with any civil consequence

Contrary view taken by the Bombay High Court in the case of SGS India Ltd. (292 ITR 93) for reopening of the assessment based on the order of the TPO in the

subsequent years



Ruling 7 –UCB India Pvt. Ltd.* (2009-TIOL-184-ITAT-MUM)


Facts of the case

► I Co is a 100% subsidiary of UCB S.A. Belgium

► I Co is engaged in the business of manufacture and marketing of prescription drugs in the therapeutic areas of allergy and asthma, central nervous system and internal medicine

► I Co manufactures intermediates, bulk drugs and formulations, both in tablet and capsule form

► I Co imports some of the ingredients or finished formulations from its parent company

► The main items imported were ‘Piracetam’ and ‘Mesna’

Import of raw materials

Overseas AEs

Outside India

In India

Indian Company(‘I Co’)



► The Appellant used TNMM method for determining the ALP at the entity level and not for the international transaction

► TPO rejected the TNMM method at the entity level► During TP proceedings, TPO requested to submit certain clarifications

regarding comparables used in TNMM method ► I Co clarified that such clarifications not possible from the data publicly

available or from public domain

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► Whether the TP documentation maintained by the Appellant are adequate and complete?

► Whether the CUP method is the only direct method, rejecting the TNMM method used by the Appellant?

► Whether the Appellant was right in applying TNMM method at entity level?



Non-maintenance of adequate TP documents► The maintenance of records in particular requirement which may have a bearing on the

international transaction is procedural and non-maintenance of the same is not such that it would affect the determination of ALP

► The Revenue should not only pick up some defects here and there as an excuse to reject the documentation

► The sum and substance has to be seen and substantive compliance should be a criteria

► The test should be, as to whether the non-maintenance or deficiency in the maintenance of some records fundamentally affects or distorts the computation of the ALP

► The term “if any” in clauses (k), (l) and (m) of Rule 10D(1) of the Rules suggests that such information should be furnished only in case where the same exists and is available with the Appellant

► The Appellant has substantially complied with the law of maintenance of records



Application of CUP► Just because it is the only direct method, it does not automatically become the most

appropriate method ► Under the CUP method, the properties of a product and accompanying circumstances

and conditions have to be evaluated for comparison► Even a minor change in the properties of the products, circumstances of trade (billing

period, amount of credit therein, etc.) may have a significant effect on the price



Application of CUP► CUP method requires a high degree of comparability along the following dimensions:

► Quality of the product service► Contractual terms (example, scope and terms of warranties provided, sale or purchase

volumes, credit terms, transportation terms, etc)► Level of market i.e. wholesale, retail, etc.► Geographical market in which the transaction takes place► Date of transaction► Intangible property associated with the sale► Foreign currency receipt► Alternatives realistically available with the buyer and the seller

► There should be a scientific basis to say that these active ingredients are identical, with the same purity, potency and characteristics

► The Tribunal rejected the CUP method adopted by the revenue authorities

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Use of TNMM Method ► If the Appellant wants to adopt a particular method to demonstrate that the international

transaction in question is at arm’s length, then it is its duty to maintain and furnish the required data irrespective of the fact that whether there is a requirement or not under other statutes like company law, customs etc.

► The burden of proving a particular method as the most appropriate method initially lies on the Appellant

► In cases where profits of an enterprise are attributable to similar transactions, and when an enterprise does not have any dissimilar transactions which distorts the profits, then the net margin derived by an enterprise as a whole may be considered for TP analysis

► The TNMM method should have been undertaken by the Appellant at the transaction level or at least segment level



Final ruling► In short, a fresh exercise may be undertaken on this aspect by both the parties,

unconstrained by technicalities and with an open mind, so as to arrive at the most appropriate method of evaluating the ALP

► In case external comparables are not available due to lack of data in public domain, then the AO may accept internal comparables including segmental data or internal TNMM

Other observations► The parent company does not seem to be interested in giving proper support to the

subsidiary company by way of furnishing data on comparables ► If the parent company does not want to come to the rescue of its subsidiary of

furnishing authentic data, then it cannot expect the revenue authorities to come to conclude in favour of the subsidiary


Ruling 8 –Skoda Auto India Pvt. Ltd.*(2009-TIOL-214-ITAT-PUNE)



Facts of the case

► I Co is engaged in the business of manufacture and sale of passenger cars

► The year under consideration is the first full year of operations of the Indian company

► The international transactions were ► Purchase of kits► Purchase of finished goods► Payment of royalties and fees for

know-how

Indian Company ‘I Co’

AEs

Purchase of raw m

aterial

Payment of R

oyalties

Purchase of finished goods

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► I Co used TNMM method for all the above transactions using average of multiple year data

► The transactions in respect of purchase of kits/cars was supported by CUP method

► In TNMM method, the margin of comparable entities was computed based on the information obtained from the publicly available database and from the Registrar of Companies to the extent available

► The TPO under the TNMM method excluded two comparables chosen by the I Co. out of six on the following basis:► Sustained losses were indicative of abnormalities ► Non-availability of financial data for relevant financial year

► The TPO compared the margin of the Appellant with the average margin of the remaining four comparables and accordingly made upward adjustment



► During the TP proceedings, the Appellant used alternate plea of using CUP method to establish that the transactions are at ALP

► Under the CUP method, the ex-factory price of the kit/car for sale in any country would be the same. Hence, the transactions relating to of kits/car are at ALP

► The TPO rejected the above method► The CIT(A) dismissed most of the grounds for want of relevant data since I

Co had not cooperated during the assessment proceedings



► Whether the Tribunal should deal with the matter on merits as the Appellant did not furnish complete information at the AO/CIT(A) level?

► Whether CUP method as used alternatively by the Appellant can be held to be the most appropriate method?

► Whether the adjustments needs to be made to the margins of comparables in respect of the following:► Multiple year data► High import duties component► Underutilization of capacity

► Whether benefit of +/- 5% range is available to the Appellant?



Non-co-operation by the Appellant► If the data is not easily available in the public domain and the same could not be

submitted before the adjudicating authority, it cannot be said that the Appellant has not co-operated and once Appellant had expressed its inability to submit the data, the same then does not amount to non co-operation

► The Appellant cannot be expected to get all details of the comparables to make comparison possible as the business model is unique

► When the information is not available in the public domain which is sufficient to make these unique comparisons, then, it is inevitable that some approximations and reasonable assumption are to be made

► Based on the facts, the Appellant cannot be said to be not cooperated during the proceedings

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Use of internal CUP ► The transactions have to be an independent transaction i.e. between two entities, which

are independent of each other► The external CUP is not the correct method when the product is unique► In absence of external comparables, the Tribunal rejected the internal comparables

used by the Appellant (transactions between AEs) under CUP method



Adjustment to the margin in respect of ► Use of Multiple year data

► The comparables has phased out various models during the three year period while several other cars were being launched

► A result being viewed in isolation would lead to absurd results► It is necessary to neutralize the impact of cyclic fluctuations of different product cycles

► High import duties► First year of complete operations and new entrant ► High import content in raw material as the manufacturing facility and vendor development were

not complete► Not possible to pass on the duty as the market was very competitive► The import content of the raw material is as high as 98.55% as against the comparables who

are in the range of 26% to 56.33% ► The business models of the comparables and the Appellant are fundamentally different and

adjustment with respect to import content has to eliminated



Adjustment to the margin in respect of ► Underutilization of capacity

► The Appellant company had utilized only 37.19% of its capacity whereas the average capacity utilization of comparable companies works out to 68.15%, hence accurate adjustment to eliminate differences were required

Conclusion► The Tribunal remanded the matter to AO/TPO for fresh adjudication on the basis of

facts, with instruction to consider:► The impact of additionally borne non-cenvatable import duties;► The analysis of imports for the subsequent years to verify reduction in imports;► The relevance of product cycle and its impact on operating margin and ► Other options to neutralize the impact of higher costs

► The issue on benefit of +/- 5% range is covered in favour of Appellant*

* Rule pertaining to +/-5% range has since been modified in Finance Act 2009

Transfer Pricing in IndiaRecent Case laws and developments

08 August 2009

99

Two Day

Workshop

On

TRANSFER PRICING

100

Transfer Pricing Audits and Controversy

08 August 2009

08 August 2009 Transfer Pricing Audits & Controversy

Page 2

Contents• Audit process• Overview of TP Audits• Managing TP Risk• Transfer Pricing Wish List


Page 3

Audit process


Page 4

Routine Audit Procedure

Audit Procedure

U/s 92CA the AO may refer determination of ALP to the TPO, with prior approval of Commissioner1 TPO would then notify

the taxpayer to produce evidence supporting transfer price as arm’s length 2

TPO would determine ALP by passing an order based on information gathered from the assessee/ other sources and intimate the AO & taxpayer

3AO would proceed to compute income of the taxpayer in conformity with ALP determined by the TPO4

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► Threshold for compulsory TP audit ► Information requested by the AO/TPO

► Copy of Form 3CEB, audited financials, tax audit report, computation of income► Copy of Transfer Pricing report and all documents maintained under Rule 10D(1)

and Rule 10D(3)► Copy of all relevant intercompany agreements► Copy of global transfer pricing policy► Details of comparable transactions with independent parties in India or outside

India

► Standard queries raised by the AO/TPO ► Updated single year financial data of comparables► Comparison of FAR of comparables and assessee► Queries on segment allocation methodologies (if any used)

Audit process


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Overview of TP Audits


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► Globally, multinational companies have identified transfer pricing as the most important tax issue

► More and more countries around the globe have introduced comprehensive transfer pricing documentation and penalty regulations

► TP audits in India► Indian taxpayers rate transfer pricing as one of the most complex tax issues to be

addressed► Acknowledgement of OECD transfer pricing principles to the extent that there is no

conflict with domestic rules► Major divergence of approaches in practice ► Threatens resolution of bilateral disputes (MAP proceedings) and increases risk of

economic double taxation► Increase in number of cases going for litigation

Overview of TP audits


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► Level of detail at TP audit level increasing► Increasing questioning and data gathering for in-depth scrutiny► Recruiting and training of specialist resources to examine more complex

transactions

► Indian Revenue Authorities have audited more than 1500 cases in the recently concluded fourth cycle of transfer pricing audits

► Quantum of TP adjustments in fourth audit cycle approx. INR 5000 crores► Increased focus and resource deployment for TP audits:

► Separate administrative structure with specialist Transfer Pricing Officers (TPOs) created for TP audits

► 23 TPOs deputed across India► Dedicated Commissioner of Appeals- CIT (A) for TP cases► Extension of time limit for completion of assessment from 24 months to 33

months


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► Convergence of TP and Customs► Implementation of recommendations by Joint Working Group on Transfer

Pricing

► Audits intensive in Information Technology, Consumer Electronics, FMCG, Automobiles and Agricultural Commodities Sector

► Ongoing discussions on introduction of an Advance Pricing Agreement (APA) regime



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► Significant adjustments to following companies:► Loss making/ low margin companies

► ‘Cost plus’ service companies with low mark-up

► Indian subsidiaries of ‘Big Global brands’

► Risk mitigated captive R&D centers

► Companies with Marketing Expenditure – Support from Associated Enterprise

► Companies paying Technical know-how/ Royalty/ Management fee (Need to fulfill Benefits test)

► Application of deeming provisions u/s 92B(2) of IT Act

► Use of un-reliable internal / external data for CUP analysis (like SVB Custom valuations)

Current Trends


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► More aggressive stands taken vis-à-vis past years► Increased focus on intangibles

► Alleging creation of intangibles by Indian subsidiaries► Allocation of increased profits to the Indian subsidiary for creating

intangibles like brand, patents, etc.► Economic ownership of created intangibles attributed to Indian subsidiaries

to justify additional attribution of profits

► Increased emphasis on alleged high-end capabilities of the Indian entity► Information based on corporate website, newspaper articles, etc

► Rejection of FAR analysis► Basis: lack of weights assigned to functions, assets and risks

► Aggregation of dissimilar transactions► Software services with BPO services, etc

Current Trends


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► Number of comparable companies selected for benchmarking has been as few as two in some cases

► Use of additional quantitative filters to screen companies► Employee costs, onsite revenue, different year end

► Inadequate consideration to business strategy, commercial realities► Inconsistent approach on acceptance of working capital adjustments► The payment of management service charges/ technical know-how has been

nullified in some cases on grounds that insufficient benefits are being derived by the Indian entity

► Use of Section 133(6) of the Act to use ‘secret comparables’► Data gathered from sources which are not in ‘public domain’ to select

comparables

Current Trends

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Managing Risk


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► Maintain proper transfer pricing documentation ► Need for comprehensive documentation for all inter-company transactions► Increased pressure for comparability analysis using local comparables► Annual economic analysis update► Evidence like comparability data of competitors, differentiation with the peer

set, hourly charge-out rates prevalent in the industry► Inter-company agreements correctly reflecting functions of parties involved► Evaluate whether mark-up needs to be enhanced based on impact

assessment and current trends

► Public documents to be in sync with tax strategy► Correctly documenting activities undertaken by the Indian entity in public

documents such as press releases, industry directories and statutory documents

► Use of superlatives and glorification may be avoided if not necessary

Managing TP Risk


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► In case of a change in TP policy, evaluate the manner in which the change should be reflected► Change in inter-company Agreement(s)► Limited to a true-up adjustment in the financial statements► Adjustment only in tax returns

► Document commercial substance of intangibles owning entity to support contribution and decision making function of legal owner of intangibles

Managing TP Risk


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Recent developments

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► Key changes announced in Finance Act 2009► Introduction of Safe Harbour Provisions

► Power given to CBDT to formulate safe harbour rules► To provide the circumstances in which the Income-tax authorities shall accept

the transfer price declared by the assessee

► Alternative Dispute Resolution (“ADR”) Mechanism introduced► Another layer of adjudication added which has authority to provide guidance to

the AO (AO has to accept guidance provided by ADR panel)► ADR panel to be a collegium comprising of three commissioners of Income-tax

constituted by the CBDT► The assessee has to file the objections with the ADR panel within 30 days of the

draft order being provided by the AO to the assessee► Directions to be issued by the ADR panel within 9 months of the draft order

provided by the AO to the assessee► The directions issued by the ADR panel are only appeal-able in the High Court.

► Change in computation methodology for +/- 5% range

Recent developments


Page 18

Transfer Pricing Wish List


Page 19

Legal issues

► Criteria for TP audit► Application of a more scientific screening process instead of a monetary

threshold► Statistical methods

► Use of IQ range, median etc instead of arithmetic mean and +/- 5% range*

► Allowing use of multiple year data

► More detailed guidance on specific TP issues► Aggregation of transactions, Services, Intangibles transactions

► Guidance on collateral consequences of TP adjustments► Compensating adjustments, set-offs, correlative relief, secondary

adjustments

* The methodology for computation of +/-5% range has been revised in the Finance Act 2009

Transfer pricing Wish List


Page 20

Administrative issues

► Introduction of Advance Pricing Agreement mechanism► Re-visit position on MAP in the absence of provisions in the relevant tax

treaties analogous to Article 9(2) of the OECD Model Convention

Documentation issues

► Guidance on treatment of intangibles should be provided► Interface of business strategies with inter-company pricing should be

considered► There is a need for developing and allowing robust risk adjustment

methodologies

Transfer pricing Wish List

105

Workshop on Transfer Pricing 7 8Aug09

Documents

Transcript of Workshop on Transfer Pricing 7 8Aug09